A derivative (in financial terms) is any asset whose value is related to the value of...
Fantastic news! We've Found the answer you've been seeking!
Question:
Transcribed Image Text:
A derivative (in financial terms) is any asset whose value is related to the value of an underlying asset. The metaphor of velocity and acceleration works well, because a small change in one (acceleration) results in a major change in the other, and so it is the case with financial derivatives. The 2008 financial crisis involved bad choices (subprime loans) that were made worse by concealment (in large bonds called CDOs) that was made MUCH worse by insuring said bonds (derivative) and underestimating the risk posed by devaluation of the underlying asset (houses). Leverage is a term that implies a larger profit and a smaller bet; reverse leverage, a made-up term, is when the bets all go wrong at the same time. For many derivatives like call options, the buyer stands to lose only the price of the option. Derivatives are NOT inherently bad (although Mr. Buffett did call them "financial weapons of mass destruction," he uses them too). BUT the investor should be aware of the downside risk associated with some of these bets. In 2008, the AIG downside risk was almost infinite, and the lack of a solvent insurer caused PANIC. So you might hear of derivatives used in a pejorative way. Look up Long Term Capital Management for another apocryphal story of making a bad bet with other people's money. Back to more mundane uses of derivatives... People like to trade and they have exchanged goods and services since ancient times. A negotiated exchange between two parties is a contract. Long ago, contracts for the future price of a commodity, like olive oil, were used to protect the grower from weather issues or demand issues. This is thought to be the origin of futures contracts. At least some of the "crop" could be hedged, before the crop even became available. Some wine stores sell futures on Bordeaux wine in a similar way. Note that the true example of a hedge is when one protects the upside and downside of a volatile market, as in a currency hedge. This has almost nothing to do and downside of a volatile market, as in a currency hedge. This has almost nothing to do with so-called hedge funds of today, which are private investors that are pretty opaque and can bet on just about anything. Look up the difference between trading Futures and Forward Contracts- same idea, but in one case, one has to actually take delivery of the goods or commodities! Be careful if this is pork bellies! Options are futures contracts for shares of stock. They have been in the news for years as a way for employees of tech companies to get rich. Now there are more restrictions on options, but there was a time when companies handed them out like candy and did not expense the cost on the balance sheet. Times change. Options of public stocks are traded on the Chicago Board Options Exchange. A call option is the right to purchase a certain number of shares (e.g. 100) within a specified timeframe and at a designated “exercise price." If the share price does not reach the “exercise price,” the option simply expires worthless. Most call options expire worthless. So why do people buy them? Because for a relatively small amount of money, the owner might hit it big IF the stock really goes up (i.e. leverage). For example, if you were holding a "lot" (equivalent to 100 underlying shares) of Amgen call options with the shares at $162/share and the share price rose to $182/share before the option expires, then a savvy investor would exercise the call options and quickly pocket $2,000 ($20/share x 100 shares). I would guess the option may have cost $200 for the "lot," and so the net would be $1800 (9x return). Not bad! Put options work similarly except the bet is that the underlying stock, index or commodity will go down in price (i.e. be less expensive) in the future. And "lower price" means going all the way down to ZERO, and so the downside risk of a put option is very high. As long as one owns the underlying stock (a covered call), the downside risk to writing (i.e. selling) a call is simply that you get some shares called away- shares that perhaps you were ready to sell anyway. Writing covered calls is a way to hedge an underlying position and bring in some revenue while you hold the stock, though it limits your upside if you have to sell the underlying shares later at the exercise price. Derivatives can be useful instruments for hedging if used correctly. One of the lessons of 2008 is that trillion dollar bets made on the sidelines can put our entire financial system at risk without the counterparty risk being known. In spite of the political backlash on" bailing out the big banks," both President Bush and Obama quickly realized, as did most of Congress, that frozen credit markets and lack of lending would benefit no one and would presage a depression for sure. Few political leaders would want their names attached to such a decision. Did a CDO exchange ever come to fruition? A derivative (in financial terms) is any asset whose value is related to the value of an underlying asset. The metaphor of velocity and acceleration works well, because a small change in one (acceleration) results in a major change in the other, and so it is the case with financial derivatives. The 2008 financial crisis involved bad choices (subprime loans) that were made worse by concealment (in large bonds called CDOs) that was made MUCH worse by insuring said bonds (derivative) and underestimating the risk posed by devaluation of the underlying asset (houses). Leverage is a term that implies a larger profit and a smaller bet; reverse leverage, a made-up term, is when the bets all go wrong at the same time. For many derivatives like call options, the buyer stands to lose only the price of the option. Derivatives are NOT inherently bad (although Mr. Buffett did call them "financial weapons of mass destruction," he uses them too). BUT the investor should be aware of the downside risk associated with some of these bets. In 2008, the AIG downside risk was almost infinite, and the lack of a solvent insurer caused PANIC. So you might hear of derivatives used in a pejorative way. Look up Long Term Capital Management for another apocryphal story of making a bad bet with other people's money. Back to more mundane uses of derivatives... People like to trade and they have exchanged goods and services since ancient times. A negotiated exchange between two parties is a contract. Long ago, contracts for the future price of a commodity, like olive oil, were used to protect the grower from weather issues or demand issues. This is thought to be the origin of futures contracts. At least some of the "crop" could be hedged, before the crop even became available. Some wine stores sell futures on Bordeaux wine in a similar way. Note that the true example of a hedge is when one protects the upside and downside of a volatile market, as in a currency hedge. This has almost nothing to do and downside of a volatile market, as in a currency hedge. This has almost nothing to do with so-called hedge funds of today, which are private investors that are pretty opaque and can bet on just about anything. Look up the difference between trading Futures and Forward Contracts- same idea, but in one case, one has to actually take delivery of the goods or commodities! Be careful if this is pork bellies! Options are futures contracts for shares of stock. They have been in the news for years as a way for employees of tech companies to get rich. Now there are more restrictions on options, but there was a time when companies handed them out like candy and did not expense the cost on the balance sheet. Times change. Options of public stocks are traded on the Chicago Board Options Exchange. A call option is the right to purchase a certain number of shares (e.g. 100) within a specified timeframe and at a designated “exercise price." If the share price does not reach the “exercise price,” the option simply expires worthless. Most call options expire worthless. So why do people buy them? Because for a relatively small amount of money, the owner might hit it big IF the stock really goes up (i.e. leverage). For example, if you were holding a "lot" (equivalent to 100 underlying shares) of Amgen call options with the shares at $162/share and the share price rose to $182/share before the option expires, then a savvy investor would exercise the call options and quickly pocket $2,000 ($20/share x 100 shares). I would guess the option may have cost $200 for the "lot," and so the net would be $1800 (9x return). Not bad! Put options work similarly except the bet is that the underlying stock, index or commodity will go down in price (i.e. be less expensive) in the future. And "lower price" means going all the way down to ZERO, and so the downside risk of a put option is very high. As long as one owns the underlying stock (a covered call), the downside risk to writing (i.e. selling) a call is simply that you get some shares called away- shares that perhaps you were ready to sell anyway. Writing covered calls is a way to hedge an underlying position and bring in some revenue while you hold the stock, though it limits your upside if you have to sell the underlying shares later at the exercise price. Derivatives can be useful instruments for hedging if used correctly. One of the lessons of 2008 is that trillion dollar bets made on the sidelines can put our entire financial system at risk without the counterparty risk being known. In spite of the political backlash on" bailing out the big banks," both President Bush and Obama quickly realized, as did most of Congress, that frozen credit markets and lack of lending would benefit no one and would presage a depression for sure. Few political leaders would want their names attached to such a decision. Did a CDO exchange ever come to fruition?
Expert Answer:
Answer rating: 100% (QA)
The provided text covers various aspects of financial derivatives including their historical origins ... View the full answer
Related Book For
Intermediate accounting
ISBN: 978-0077647094
7th edition
Authors: J. David Spiceland, James Sepe, Mark Nelson
Posted Date:
Students also viewed these finance questions
-
The scene is a conference room on the 10th floor of an office building on Wall Street, occupied by Anthes Enterprises, a small, rapidly growing manufacturer of electronic trading systems for...
-
Managing Scope Changes Case Study Scope changes on a project can occur regardless of how well the project is planned or executed. Scope changes can be the result of something that was omitted during...
-
Which of the following pairs of steps in the programming process is in the correct order? a. Code the program, plan the logic b. Test the program, translate it into machine language c. Put the...
-
Mostert Music Company had the following transactions in March: a. Sold music lessons to customers for $10,000; received $6,000 in cash and the rest on account. b. Paid $600 in wages for the month. c....
-
Both the competitive firm and the monopolistically competitive firm ______. a. May earn short-run economic profits b. Will not earn economic profits in the long run c. Both may earn short-run...
-
Why might a plaintiff wish to serve a demand letter on the defendant before filing a lawsuit?
-
The following information was drawn from the annual report of Sierra Home Builders (SHB). Required a. Compute the percentage of growth in net income from 2016 to 2017. Can stockholders expect a...
-
(d) (e) While you are browsing the bank's website, you find that DBS quotes an interest rate of 1.6% per annum on a car loan. Incidentally, you are thinking about buying that cheapest possible...
-
A 9.5 API bitumen produced from an oilsands production facility on average contains 2240 g/g salts on entering the bitumen upgrader facility. The nameplate capacity of the upgrader is 67,000 barrels...
-
Does the food service operation face financial risk when they have stockouts?
-
The blue samurai, a japanese restraurant, has an asset turnover of 3.5 the total assets were 95,000 what are net sales for the blue samurai?
-
Gatekeeper Manufacturing reported 50,000 physical units that were 100% complete for direct materials during the period. In addition, the 50,000 physical units were 100% for conversion costs. In terms...
-
What are the emerging trends and challenges in the field of electrochemical engineering, particularly in the development of advanced materials and electrode architectures for high-performance energy...
-
A firm issued 100,000 shares of corporate bond. The bond has a maturity of 15 years, 5% coupon rate with semi-annual coupon payments, $1,000 face value, and a price of $950. Suppose the corporate tax...
-
Sam's Stores Enterprises is now at the end of the final year of a project. The equipment originally cost $22,500, of which 60% has been depreciated. The firm can sell the used equipment today for...
-
Describe the general ways that the revised Form 990, applicable for tax year 2008 and beyond, is different from previous versions.
-
The Commonwealth of Virginia filed suit in October 2011, against Northern Timber Corporation seeking civil penalties and injunctive relief for violations of environmental laws regulating forest...
-
Manufacturers Southern leased high-tech electronic equipment from International Machines on January 1, 2013. International Machines manufactured the equipment at a cost of $200,000 and lists a cash...
-
In 2013, Winslow International, Inc.s controller discovered that ending inventories for 2011 and 2012 were overstated by $200,000 and $500,000, respectively. Determine the effect of the errors on...
-
Canada's Wonderland is an amusement park in Vaughan, Ontario. Over 3.5 million people visit Wonderland each year between May and October. It covers 330 acres and has more than 200 rides and...
-
The accounts of Custom Pool Service, Inc., follow with their normal balances at June 30, 2020. The accounts are listed in no particular order. Prepare the company's trial balance at June 30, 2020,...
-
Refer to exercise E2-17. Record the transactions in the journal of Joseph Ohara Dental Clinic Ltd. List the transactions by date, and give an explanation for each transaction. Exercise 2-17 Joseph...
Exercise Book GED Test Common Core Achieve Social Studies 1st Edition - ISBN: 0021355738 - Free Book
Study smarter with the SolutionInn App