Derivatives are a complex and potentially dangerous region. Here’s how to spot the warning signs.
To be a successful investor, you don’t need a comprehensive knowledge of derivatives. But you do need a basic understanding of what can go wrong and what the danger signs are—and that’s what this article is all about.
In a nutshell, derivatives are financial devices which derive their worth from some underlying resource or reference point. Consider the easy example of a wheat character. After taking the relevant farming considerations into account, he proves that his forthcoming pick is likely to be around 5, 500 tonnes. So he gets into a contract now to provide that tonnage of whole wheat to a buyer at an decided price of $ 200 per charge. Locking in the price nowadays removes the risk of it dropping below that level (as well as the benefit of this moving higher) and enables him a greater degree of assurance in preparing his budget for the year. This process is known as hedging—a phrase which, in its finest form, should be synonymous along with ‘removing risk’.
When settlement day time arrives, the farmer does not usually deliver the wheat to the person on the other side of the agreement. That’s because that person, the particular ‘counterparty’, may well be a financial institution thousands of kilometres away. What usually happens is that an amount of cash changes hands between these two parties, representing the difference between the contract price and the market price on settlement day. the particular farmer then takes their grain to the nearest hassle-free silo and receives the market price. So, if the whole wheat price has moved to dollar 230 per tonne, our own farmer collects $ 1 . 15m (5, 000 by $ 230) from the aussie Wheat Board and will pay $ 30 per charge, or $ 150, 000, to the counterparty of his type contract. His net outcome is $ 1m, or a price of $ 200 per tonne—the one he locked within at the start of the contract.
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