Wealth Building Techniques

What is a derivative?

For those of you who have always wanted to know “what is a derivative”, I will do my best to explain this subject in the most simple of ways.

Undoubtedly, derivatives is one of those subject matters that gets lots of attention in the newspaper but is poorly understood by the masses. Even those who specialize in the finance arena including CFOs, and Accountants, do not fully understand this subject matter. But understanding the basic concept behind a derivative need not be a complicated task.

Almost all of us have used a credit card at least once in our lifetime. In fact, in today’s world, we hardly ever need to carry around a wad of cold, hard, physical cash. In this respect, we can think of the credit card as a derivative instrument. Technically speaking, a credit card is simply a worthless piece of plastic with some numbers plastered on it. And yet credit cards have become as prevalent in our society, even more so than cash mainly because credit cards come with the backing of the credit card company itself.

For this reason, we can view a credit card as a ‘derivative’ of cash. It may look different. It may feel different. But it serves the same purpose as cash. Moreover, many would even say that a credit card is better than cash in that it offer rewards and benefits. Also, losing your credit card is never as bad as losing physical cash. If you lose your credit card, the card company can immediately deactivate your card. Finally, credit cards allow users to pay back outstanding debts within a certain time frame without any interest. How great is that?

Make no mistake though, you can also be burned by having a credit card in ways that ‘cash’ cannot. Generally, you never want to miss a credit card payment otherwise the penalties for late payment can be astronomically high.

So, just as consumers can use ‘credit’ instead of ‘cash’, investors can use derivative instruments without having to purchase Shares outright.

One reason as to why an investor might choose a derivative instrument is the fact that derivatives often require less of an initial cash outlay. If IBM stock trades at $100, that means an investor needs to have $10,000 to purchase 100 shares of IBM.

A derivative play such as a call option, on the other hand, might only require 1/10th of that amount (ie. $1,000). This is a great strategy for those investors who do not want to expose themselves to more than $1,000.

Of course, call options have their drawbacks. One is “time”. Call options expire after some maturity or expiration date. whereas shares can technically last into perpetuity. For example, a 100 July 2011 IBM Call Option is a call option on IBM stock that expires in July 2011. This call option only has value on the expiration date of July 2011 if IBM trades above $100. ‘July 2011′ is known as the ‘expiration date’ and ‘$100′ is known as the ’strike price’ . If IBM stock happens to trade below $100 on the expiration date, the call option expires worthless.

The other drawback with options is that they require investors to pay a ‘premium’ . Investors basically lose their entire premium if the call option becomes worthless on the expiration date.

Another derivative instrument is called a put option. Like a call option, a put option will have a particular expiration date and strike price. A put option is interesting in that it allows investors to insure or to protect their portfolios from falling share prices. Many banks and life insurance companies engage in put strategies when designing principal protected investments/notes.

Technically speaking, puts and calls are the building blocks for almost all derivative strategies. The key point to remember is that options come with different strike prices and different expiration dates attached to them. So in the IBM example above, we spoke about a 100 July 2011 call option. Likewise, there would be call options with strike prices of $105, $110, $115, and so on. And similarly, you could find call options with expiration dates of Mar 2011, August 2011, Sep 2011, and so on.

While I won’t go into the ins and outs of all the possible derivative strategies, the important point to know is that there are any number of derivative strategies that can generate different levels of payoffs.

Just as an artist creates hundreds and thousands of colours from three primary colours, namely red, blue, and yellow, so too is the nature of derivatives.

Jeff Kaminker, President Frontwater Capital

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About the Author

Jeff Kaminker. Jeff is licensed as a Portfolio Manager by both the Ontario and Alberta Securities Commissions. He holds an MBA and Engineering Degree (With Honours) and is a member of the CFA Institute and the Professional Engineers Society.

Jeff has over 15 years capital markets experience. Prior to founding Frontwater, he served as Senior Director, George Weston Limited where he led mergers and acquisitions and was responsible for running a $500 million commodity portfolio using advanced derivative strategies and risk management techniques. Jeff currently works with a number of large corporations in structuring risk management and hedging programs.

Financial Derivatives Explained in Ten Minutes – Re: Derivative Markets and the 2nd Great Depression

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