Roanoke Times
Copyright (c) 1995, Landmark Communications, Inc.
DATE: SUNDAY, February 12, 1995 TAG: 9502100034
SECTION: BUSINESS PAGE: F1 EDITION: METRO
SOURCE: DONALD M. CHANCE SPECIAL TO THE ROANOKE TIMES & WORLD-NEWS
DATELINE: LENGTH: Medium
While that might not exactly make you a Wall Street rocket scientist and you're unlikely to be the next treasurer of Orange County, Calif., you've still exhibited some of the behavior that has led to the explosion in the use of derivatives. And the important thing is, there was nothing unsound about what you did.
You entered into an agreement with another party in which each of you would do something for the other. Your insurance policy is a contract between you and an insurer in which you pay the insurance company some money - your premium - and the company promises to pay you some money if something bad happens. That's how one particular type of derivative - a put option - works. (A put option is a contract that gives the seller the right to sell a specific number of shares of an investment at a specified price on a certain date.)
A derivative is a contract between two parties, each of whom promises to do something for the other. The contract has a defined life and calls for one or more cash payments to be made. The amounts of those payments are determined by how something else - the price of a specific stock, an interest rate, a foreign currency exchange rate, or a commodity - does. There are several types of derivatives.
Options are derivatives that have one party - the buyer - paying a premium to the other party - the seller - and receiving either the right to buy or sell something at an already agreed-on price. Many investors use options as a means of buying or selling a stock at an attractive price. Owners of stock use options as a means of protecting their stock against loss. In fact, this works exactly the same as the insurance policy we described.
Think of your stock crashing as like your house burning down. The homeowner holds insurance as protection the same way an investment manager might use options as protection.
Buyers of options stand to lose all of their investments, but this is normally a small amount relative to the value of stock or whatever the option is based on. Writers, however, can lose substantial amounts of money if they do not enter into other transactions that offset the risk.
Another such popular investment is futures, which is a contract between two parties in which one party agrees to buy something at a future date but at a price agreed on today. The other party agrees to deliver that something at the agreed-on price.
Futures contracts are traded on futures exchanges in Chicago, New York and other major financial centers around the world. Futures contracts are typically based on stock indexes, bonds, foreign currencies and commodities.
In contrast to an option, the parties entering into the futures contract do not exchange any money up front. Although there is potential for substantial loss, many, if not most, experienced traders combine futures with other transactions and end up with much less risk than is probably present in your retirement fund right now. And you thought THEY were the speculators.
In addition to futures and options, there are several other types of derivatives that are used mostly by large financial institutions and corporations.
Forward contracts are similar to futures. Perhaps the most important and widely used derivative is the swap, a contract between two parties in which one party agrees to make one set of regularly scheduled payments and the other party makes a different set of regularly scheduled payments.
What's the big deal? At least one set of payments is unknown when the contract is initiated. What happens to something like stock prices, interest rates, currency rates or commodity prices determines what the payments will be. This market has reached a size of almost incomprehensible proportions. Corporations and banks are using these transactions to protect themselves against risks that they face in their businesses.
Derivatives don't create risk; they're just a simple means of managing risk. While they can be misused - as was the case in Orange County and a few other highly publicized stories - not using them can make as much sense as failing to insure your house. You should hope your pension fund manager is aware of and taking advantage of the benefits of sound risk management through derivatives.
Donald Chance a professor of finance, insurance and business law at Virginia Tech's Pamplin College of Business.
by CNB