DERIVATIVES

Derivatives are the most maligned of all financial instruments, thanks in large part to the media sensationalizing numerous derivative blowups. History is littered with corpses of derivatives victims.  Barings Brothers, bankers to the Queen, was brought to its knees in 1995 by rogue derivatives trader Nick Leeson. Hot on the heels of Barings, was Long Term Capital Management - a fund that counted the very same Nobel laureates who invented the Black and Scholes pricing model on their payroll. The fund went bust under the weight of toxic leverage that only derivatives can provide.  
 
In the 2008 financial crisis, derivatives once again were not far from the crime scene. Subprime mortgages by themselves are incapable of bringing the world’s financial system to the brink of collapse. It was the levered derivatives wrapped around these loans in the form of credit default obligations that forced the collapse.  
 
Warren Buffett said after the financial crisis that derivatives were instruments of mass destruction and they should be prohibited. Buffett is a man with a huge intellect but this comment only focuses on one aspect of derivatives.
 
The reason most people fail to understand derivatives is that they are esoteric. They are intangible, synthetic and do not exist in the physical world. We cannot see gravity, but know it exists. The gravitational pull of derivatives has never been stronger.  
 
Added to this lack of physicality is the fact that derivatives are inherently schizophrenic. They can be used to increase risk or mitigate risk. They are akin to a surgeon's scalpel. A sharp knife is dangerous in the hands of a child. But in the hands of a trained surgeon, they are indispensable for success.  Why should you, the rebel financier, give a damn about derivatives?
 
They are exceptionally powerful tools in the world of financial engineering. There are two ways to build a bridge. You can build it fast, cutting corners and saving on costs. Or you can build it slowly, methodically, scientifically and with high-quality materials. Both bridges will work in the short to medium term. Over the longer term, it is clear which bridge will weather the natural, human and mechanical elements.  
 
In finance, be it in the management of your investments or the management of your business, you can do it the easy way, or you can make use of the most advanced and robust principles. Derivatives form the basis of robust financial construction and are important tools for those looking to build a long term and enduring career in finance.
 
 This section is pitched at an intermediate level. It does not get into the weeds of mathematical calculations and advanced formulae. After reading this section, you will understand key principles of derivatives and be able to implement strategies in the management of both assets and liabilities.  
 
THE DYSFUNCTIONAL DERIVATIVES FAMILY
 
By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives.
Alan Greenspan

 A derivative is an instrument that derives its value from an underlying asset. A derivative draws its life from this asset and cannot exist without it. You can think of it as a relationship of strong codependence. If you destroy the underlying asset, you destroy the derivative.  
 
Derivatives are not complex instruments to understand. Strong forces of self-preservation and greed within the derivative community have created the perception that derivatives are complex. Let's start with the self-preservation.  
 
If I am a brain surgeon, do I want to teach my patients how to operate on the human brain? Hell no. Firstly, that is not my job and secondly, if they knew, that would put me out of a job. The surgeon wants to give patients just enough information to achieve two results. Firstly, inform them of what is going to happen and secondly convince them that there is absolutely no way in hell they could do it themselves.  
 
The second point is greed. The less the person knows about the operation, the more the surgeon can charge. Medicine is a business and is driven by as much greed as the stock market. If you think otherwise, pop another valium and power on with that letter to Santa.
 
When you look at the family of derivatives, it is easy to be overwhelmed by its sheer size and dysfunctionality. There are sisters you have hated all your life, brothers who never put back your stuff, dirty uncles who are always showing you inappropriate photos on their phone, cousins five times removed by marriage, nieces whose names you never remember, nephews whose names you don't want to remember, grandfathers who are always asking you to pull their fingers and aunts who always want to kiss you on the mouth.  
 
In the derivative family, there are swaps, futures, forwards, contracts for difference, knock-in and knock-out options, American, European and Bermudan options, point-to-point and path-dependent options, digital, barrier, Asian, quantos, no-touch, double no-touch, triple no touch. The list goes on.
 
Amidst all this chaos and randomness, the derivative family tree can be broken down into only two branches.  There are only two kinds of derivatives - forwards and options. Futures are listed forwards and swaps are a series of forwards stapled together. Contracts for difference are disguised forwards. All other derivatives belong to the options part of the family. Options stand apart from forwards because they cost something. This is known as premium. Human beings have an inherent fear of two things – large venomous reptiles and the payment of option premiums (or premia if you want to be obnoxious and pretentious).