Tuesday, May 10, 2011

Moola Lingo: Derivatives

Derivatives is a money-word that bounces around quite a bit in the business news, often in the context of traders' "bad behaviour" and the "blind greed" of the American bankers who drove the U.S. into the mortgage meltdown and the rest of us into the global financial crisis of 2008. But, seriously, I had no idea what a derivative was until I decided to invest far too many kid-free hours of the last two days into not only finding out what it means but how I might translate into something that the average financial illiterate (and his or her five-year-old) can understand.

Yes. You read that right. I'm not only working on how to teach we grown-ups what a derivative is, I am also taking a crack at introducing it to five-year-olds. If you are thinking that I'm crazy, you are not alone. Last week I had the chance to ask 40 elementary school teachers whether or not kids in primary school should be introduced to moola lingo such as ETF, liquidity, T4, bonds, passive income, equities, overdraft, capital gains, etc.

Almost all of the teachers said, "No way!"

I disagree, of course. For me financial literacy comes down to two things: vocabulary and confidence. It's never too soon to start building either of those highly valuable personal commodities. And as someone who has logged many hours as a coach, I know that sometimes we grow the most when the bar is set higher than we think we can handle. When it comes to moola lingo, the word "derivatives" certainly fits the bill as a training tool. So put on your helmet. Here we go.

Not the Real Thing
A derivative is NOT an original thing. A derivative gets its meaning and its value from something else. In science, think of opium's derivatives: morphine and codeine. In etymology (the study of words), think of the Latin word "aqua" and its many derivatives such as aquamarine, aquatic, aquarium and Aquaman. Just think, without the Latin word for water (aqua) Norris and Weisinger might have named their underwater hero Soggyman or Wetman.

In moola lingo, it's the same idea. Derivatives cannot exist or have meaning or value without the thing that it is based on. There must be real wheat for flour and real pork bellies for bacon before you can create and trade in corn futures or pork belly options. (Options and futures are the two most common kinds of derivatives.)

According to Investopedia.com a derivative is "a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties." Here's an example.

Short & Long on Balls
Imagine a market where everything baseball is bought and sold. A coach needs new balls for her team. There is no avoiding it. She will have to spend money on balls but, hopefully, not too much. The annoying thing is that the price of balls goes up and down all the time. Sometimes they cost $2 each, sometimes they go as high as $10 each. She does not want to pay $10 for each ball. She needs 100 balls, so that would cost $1000!

The day the coach goes to the baseball market, balls are selling for $5 each. She doesn't need the balls today (she doesn't even have enough money to buy today) but she wants to buy the balls at today's price. She goes up to a ball guy and tells him that she will buy 100 baseballs from him at $4 each and that she will need them delivered to the field on opening day. The guy agrees because he thinks that the price of balls is going to go down to $3 when all the other ball sellers come to the market next week.

The coach and ball guy write all of those details on a piece of paper. That piece of paper is now called a "futures contract" and it's a kind of derivative. Like the word "Aquaman" depends on the existence of the Latin word "aqua," this piece of paper depends on the existence of real baseballs and how much they cost at the market on any given day.

The coach is called a "speculator" who is "long" on balls, which means that she thinks that $4 is a good deal because the price of balls will probably go up. The ball guy is called a "hedger" who is "short" on balls, which means that he thinks the price of balls is going to go below $4 and he wants to get as much money for his balls as he can.

On opening day, the price of balls at the baseball market is $10. The ball guy delivers the 100 new balls. The coach pays him $400 dollars and is really happy. She saved her team $600 dollars. The ball guy is not happy. He lost $600 because the futures contract says that he must sell 100 balls for $400 when he could have sold those 100 balls that day at the market for $1,000. Poor guy. But what if the price of balls on opening day had been $2 each. Then the ball guy would be happy that he had the coach locked into paying $4 per ball. The coach would have been annoyed at paying $400 instead of $200.

As you can see, how it works out for the speculator (the coach) or the hedger (the ball guy) totally depends on how many balls and how many coaches needing balls will be at the market on a certain day. No one can control how much something like a baseball will cost tomorrow, the next day or next Wednesday. This is why derivatives are considered useful.

Sellers like the ball guy want to be sure they get a good price for their balls at the market. Buyers like baseball coaches want to buy their balls for as little money as possible. They talk, come up with a price for baseballs that they both like and set a date for the balls to be delivered to the buyer. Maybe having a futures contract helps them both sleep better at night knowing that no matter what the price of baseballs is tomorrow, they have a deal.

Where a speculator or hedger might lose sleep or have nightmarish flashbacks to 2008 is when the contracts themselves are bought and sold on the derivatives market (this is not something that I can visualize yet) or when a contract comes due and there isn't enough money to pay it out (apparently when buying a derivative, you don't need to have the all the cash on hand, just a small percentage of the face value of the contract).

As you can imagine, my fellow financial illiterati, there is much more collateral lingo attached to derivatives that we can learn. But not today. I think we've done enough of a workout. I know I have...

Copyright 2011. Laura Thomas. All Rights Reserved.
For reprint permission contact moneyme@telus.net.

1 comment:

  1. Hi Laura, Great post! I've done very little financial literacy stuff on my parenting blog so far, but intend to do so in the future.

    You mentioned that you can't imagine a futures or an options market. Most of the traders in futures do not take delivery of the product. They resell the contract.

    In your baseball story idea, perhaps the ball supplier heard that a big manufacturer was going out of business, so there might be a shortage of balls and ball prices might go up therefore. He could then try to buy supply from someone else to cover his side of the contract, perhaps for $5 per ball, after having changed his mind about the direction of ball prices. So he would have lost $100, but the new ball guy will be responsible to deliver the goods at a loss of $500. The ball guy will pay the new supplier with $100 cash and the existing contract.

    As you noticed, the coach only pays upon delivery. That's why coach doesn't need to have the money when the contract is signed, and the ball guy doesn't need to prove he has the goods. Brokerages will back these transactions (margin, which is like credit or a loan), and many people have lost a lot of money by buying more than they could afford to really pay for. Also, the original ball guy only needed $100 to shift the $500 transaction to another supplier.