What is a derivative?

Discussion in 'Economy' started by foggedinn, Jan 17, 2010.

  1. foggedinn
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    foggedinn VIP Member

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    I confess a degree of ignorance. I have only been exposed to derivatives tangentially.

    Coming from a process control background, I'm familiar with something called a PID (proportional/integral/derivative) controller. Proportional control will only control within a band. Adding integral action will allow a controller to maintain set point. Derivative action is rarely used in highly specialized control situations where anticipatory control is required. Unskilled use of the derivative function will quickly send a loop out of control and usually requires system shutdown and restart.

    If my analogy is appropriate, there seems to be a lot of unskilled use of the derivative function in our financial system. I also doubt it's neccessity in financial control.

    The very few who actually use it correctly can either make money or avoid some losses. For the rest, they would be better off going to the crap table.
     
  2. B L Zeebub
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    B L Zeebub Active Member

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    a dyslexic conservative
     
  3. Barb
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    Barb Carpe Scrotum

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    Okay, so its the Huff Post. There are two very good videos here that will explain it:

    Credit Derivatives Explained: A HuffPost Guide To The Economic Meltdown (VIDEO)
     
  4. Baruch Menachem
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    Baruch Menachem '

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    I can give you examples.... things like futures are derivatives. The underlying thing is barrels of oil, but you are not trading oil, you are trading the right to sell or buy oil for a set price at a set date.

    Same thing with stock options. you are not trading the stock. You don't even have to have it. You are trading the right to buy or sell the stock at a particular price within a particular time frame.

    You can do the same thing with any commodity. Derivatives are very useful for people who need to budget, and need to know what something will cost on a given date. Others need to know their cash flow, so they sell derivatives to guarantee a particular price. Say you own a refinery. Lucky you. You have to run the thing 24/7 or you run a loss. So you contract with people to guarantee delivery of your feedstock at set prices at set times. On the other end, you want to make sure you make a profit, so you sell the gasoline future to people at the other end.

    In theory, this is supposed to make things easier to manage, reduce risk, and make sure everyone knows their costs as commodities run through the system.

    there are also financial derivatives. That is the whole basis of Fannie/freddie. Fannie and Freddie packaged up a thousand loans into a package and sold the package as a mutual fund to investors. Investors want to make sure they lock in a return, so they create second level derivatives of the fannie/freddie loans. This is where things get very dicey.

    Essentially, people trade risk.

    Insurance is a major derivative market. Your car dealer wants to make sure he gets paid, so he requires you to insure the car. As far as the dealer is concerned, your insurance policy on the car is a derivative, as the insurance company is taking the risk on the loan away from the car dealer.
     
  5. eagleseven
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    eagleseven Quod Erat Demonstrandum

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    Barb's and Baruch's explanations are sufficient, I believe.
     
  6. william the wie
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    william the wie Gold Member

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    Unless you are engaged in barter your economic exchanges are made with derivatives solely. The idea that the currency, credit cards, debit cards and checks you pay your bills with are all derivatives not just stocks, bonds and their derivatives is hard to grasp. The legal tender clause on the currency you use says that the government issuing it will use force to get people to accept as they would a barter arrangement. Obviously cards and checks are derivatives of currency.

    Treating lower order derivatives as non-derivatives is nuts but it is a common fallacy that gets a lot of people in a lot of trouble. That is why the argument for specie tends to get so heated, the majority does not think through the fact that their very existence is based on 2nd or higher order derivatives.
     
  7. Neubarth
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    Neubarth At the Ballpark July 30th

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    In a way it is gambling.

    On individual life insurance you are betting that you will die. The insurance company is betting that you will live.

    Either way, you lose.
     
  8. Toro
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    Toro Diamond Member

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    Derivatives are a vital instrument to spread and reduce risk for legitimate hedgers, but they are also used to make bets by financial institutions. Some bets are legitimate - it is easier to gain exposure to the corporate bond market through derivatives than it is buying the actual bonds - as derivatives allow investment plans to gain exposure which reduces overall volatility. However, many - including me - use derivatives for leveraged speculation.
     
  9. Neubarth
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    Neubarth At the Ballpark July 30th

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    DXD is a great short term buy and sell if you are convinced that the market will go down in the coming days. I am in it right now and wonder if I should have sold on Friday afternoon.
     
  10. Baruch Menachem
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    Baruch Menachem '

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    Bear in mind that most trade able derivatives are highly leveraged. Your investment can go from worth thousands to worth pennies in the course of a day. And you can be on the hook for the full value of the underlying security as well. It is not for those who have trouble saving for the rent, or for those who are risk adverse.

    Dealing with derivatives is like playing chicken on the Santa Monica Freeway.
     

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