You might have heard others talk about derivatives. What are
derivatives and how do they work? Derivatives are one of the most
important financial innovations in history, but they are often
misunderstood.
They are securities whose value is determined by or derived from other underlying assets like shares, land among others.
Derivatives
can help stabilise the economy or bring the economic system to its
knees in a catastrophic implosion due to an inability to identify the
real risks, properly protect against them, and anticipate so-called
“daisy-chain” events where interconnected corporations, institutions,
and organizations find themselves instantaneously bankrupted as a result
of a poorly written or structured derivative position with another firm
that failed; a domino effect.
Most derivatives are
based upon the person or institution on the other side of the trade
being able to live up to the deal that was struck.
If
society allows people to use borrowed money to enter into all sorts of
complex derivative arrangements, we could find ourselves in a scenario
where everybody carries these derivative positions on their books at
large values only to find that, when it’s all unraveled, there’s very
little money there because a single failure or two along the way wipes
everybody out with it.
The crash of 2008 in the stock market and the real estate market was largely the result of a derivatives market run amok.
The
problem becomes exacerbated because many privately written derivative
contracts have built-in collateral calls that require a counterparty to
put up more cash or collateral at the very time they are likely to need
all the money they can get, accelerating the risk of bankruptcy.
It could very well evaporate on you no matter what you’re carrying on your balance sheet.
Call
options and put options, which can be used conservatively or as
extraordinarily risky gambling mechanisms are an enormous market.
For
example, you can get other people to pay you to buy a stock you wanted
to buy (loaning shares), not a popular product in the Kenyan market.
Exchange
traded options are, from a system-wide standpoint, among the most
stable because the derivative trader doesn’t have to worry about
so-called counterparty risk.
While they can be
extremely risky for the individual trader, from a system-wide stability
standpoint, exchange traded derivatives such as this are among the least
worrisome because the buyer and seller of each option contract enters
into a transaction with the options exchange, which becomes the
counterparty.
Granted, as part of compensation for
working for a company, employee stock options are a type of derivative
that allow the employee to buy the stock at a specified price before a
certain deadline.
The hope of the employee is that the
stock increases in value substantially before the derivative expires so
he or she can exercise the option and, commonly, sell the stock on the
open market at a higher price, pocketing the difference as a bonus.
More
rarely, the employee may opt to come up with all of the exercise cost
out of pocket and retain his or her ownership, accumulating a large
stake in the employer.
While
futures contracts exist on all sorts of things, including stock market,
commodities, futures are predominately used in the commodities markets.
Imagine you own a farm in Molo. You grow a lot of potatoes.
You
need to be able to estimate your total cost structure, profit, and
risk. You can go to the futures market and sell a contract to deliver
your potatoes, on a certain date and a pre-agreed upon price.
The
other party can buy that futures contract and, in many cases, require
you to physically deliver the potatoes. Laikipia ranchers or Kimalel
goat auction can sell futures for their cattle.
All of
these derivative contracts keep the real economy going when prudently
used as they permit the transfer of risk between willing parties to lead
to greater efficiency and desirable outcomes relative to what a person
or institution is willing and able to expose to a chance of loss or
volatility.
Companies, banks, financial institutions,
and other organisations routinely enter into derivative contracts known
as interest rate swaps or currency swaps. These are meant to reduce
risk.
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