derivatives……….?
Can someone please explain (in simplified terms if possible) what derivatives are in relation to investing and why they are commonly associated with hedge funds?
Thank you.
- Please no copy and paste answers from the internet!
- *Continuing the discussion from the original post found here.
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March 8th, 2010 at 8:49 pm
Derivatives are investment instruments that derive their value from the movement of another security. The most common derivatives are option contracts (calls and puts) which derive their value from the movement of an underlying stock or index, and future contracts which derive their value from an underlying index, currency, or commodity. There are also a number of much more exotic derivatives as well. In general a derivative is a more sophisticated investment option and a thorough understanding of the underlying security it derives its value from, and the market environment are essential to trading derivatives. They can be very risky on their own but when used as a hedge to the main security (like covered calls) they can very effectively mitigate risk if you know what you are doing. Hedge funds are often associated with them because they tend to use hedging strategies that require them, to effectively use derivatives you are required to use leverage (they are notional value instruments that can only be purchased in a margin account) and hedge funds are able to employ these strategies freely because they are meant for high net worth and sophisticated investors, while mutual funds and ETFs are limited by the 40 Act from using these types of strategies in any significant way.
March 8th, 2010 at 9:25 pm
Definition: a financial product whose value is derived from some other financial object or process.
Explanation: a (stock) option is the best, easiest derivative for most people to understand. If I buy a July Call option for Microsoft @ $25.00, I am buying the option to buy 100 shares of Microsoft stock at $25 each between now and July 17, 2009 from a seller who is required to sell it to me if I say so. The value of that option is derived from the price of Microsoft stock “today” and the number of days until the contract ends (7/17/09).
The hedge fund association is really a red herring. It depends a great deal as to your definition of “hedge fund.” That is, what is the question and what is purpose of the explanation.
On the one hand, complex, highly leveraged derivative products helped destroy the modern banking system 2007-9, but it was mortgage brokers (Fannie Mae, Freddie Mac, as primaries) and insurance companies (AIG, front & center) in combination with traditional banks (Citigroup, et al) and investment banks (Bear Stearns, Lehman, et al) that actually drove the Titanic into the iceberg.
On the other hand, derivatives like options, futures and even currency (the US Dollar & the British Pound), are every day, salt of the earth things. They make the modern world possible and everyone uses them, whether or not they even realize it.