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
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 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.
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.
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.
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