WHAT IS IT?
A derivative is a financial security (fungible, negotiable financial instrument that holds some type of monetary value) with a value that depends on other asset or more than one asset, and the price of the derivative holds on to fluctuations of the derived asset. More precisely, it is a contract between two parties, or more, that set the price at a level to avoid the market fluctuations. Usually, the derived assets are purchased through brokerages, and the most common ones are stocks, bonds, currencies, commodities, and etc.
HYPOTHETICAL EXAMPLES F THE MAIN USES OF DERIVATIVES:
To hedge risk (with the objective of minimizing risk in the physical market) > Imagine the example of a wheat producer and a bread manufacturer. A fall on the wheat price is bad for the wheat producer, but it’s great for the bread manufacturer, because he will buy the wheat that he needs to produce the bread at a cheaper price, in opposite to that, a rise on the wheat price is good for the its producer, but bad for the bread manufacturer. So, if the wheat producer expects that the price of wheat is about to fall, and the manufacturer expects that the price of wheat is about to rise, the two parties can celebrate a contract, fixing the price of wheat. If the producer is right, then he “wins” because the price is now fixed by that contract and the manufacturer “loses” because he would purchase one of his key inputs for cheaper than it is, and vice-versa.
Speculating derivatives (In this case, a speculator uses his/her knowledge to evaluate the market and the direction that it is taking) > For the example of stocks, the investors can sell the stocks that they held on if they think the price is high, and when it drops they buy the same stock again to obtain some profit.
As easy as it seems, not all what derivatives bring are benefits, such as having non-binding contracts, leverage returns, advanced investment strategies, and others, nonetheless there are many wrong paths that can be taken, and even though there are more, the one that will be talked about is the high possibility of being scammed. Because there are people that know little about derivatives or are beginners (maybe some professional investors), scam artists take advantage of that position and use derivatives as a way to build complex schemes.
A great example of a complex scheme, and the most famous until now, is Bernie Madoff ponzi scheme. Caught in2008 and sentenced to 150 years in prison, Bernie Madoff used the so called ponzi scheme, called after Charles Ponzi, taking from his investors around $65 billion, not just rich investors but also regular people, who were attracted by the high returns promise.
Therefore, I would say, even though all people should invest, it should be a very thought through experience, and specially if it is someone that doesn’t have much or any experience and knowledge at all.
This article was published in our September 2020 Newsletter
Catarina Matos, BSc in Management