Item 40 on the July 14, 2009 agenda for the Board of Supervisors is a report on the Orange County Employee Retirement System (OCERS) using derivatives to help manage pension funds. http://cams.ocgov.com/Web_Publisher/agenda07_14_2009.htm The objective is to get higher returns and level out risk by using returns from derivatives to offset losses in other areas of the pension portfolio. However, derivatives come with their own set of problems.
What is a Derivative?
A derivative is an asset that exists and gets its value from another asset. For example, if you have a bond, you will receive a series of interest payments over the life of the bond and have the principal of the bond returned to you when the bond matures. You can make the bond into a derivative by separating the interest payments from the principal. You could then sell the right to receive the principal when it is due to one person and the rights to receive the interest payments to another person. You have created a derivative.
Are there other Derivatives?
Separating the principal and interest of a bond is the simplest form of derivative and the least risky. Other examples of derivatives include currency swaps (example - selling US dollars and buying Chinese Yuan), forward contracts (agreeing to buy 5 train cars of Number 1 Idaho potatoes on June 1, 2012), option contracts (having the right to buy but not being obligated to buy the 5 train cars of Number 1 Idaho potatoes on June 1, 2012.) These are simple examples of common derivatives. There are many more complicated and exotic derivatives which are used.
Are Derivatives Risky?
The bond derivative is of low risk because it is easy to calculate the amount of money each is worth at any given time. For other derivatives, calculating the value gets trickier, and that's where people get into trouble. For instance, if you swapped US dollars for Japanese Yen with a target date in 2013, how do you decide how much this is worth today? You can assign a value, but the value can and will change depending on market conditions. Through no additional work on your part, you can make a lot of money. And, through no additional work on your part, you can lose a lot of money.
What is Leverage? How can Leverage Help and Hurt me?
Leverage is a great TV show on TBS and a way to put in a little money to get a lot of benefit. For example, if you bought your home with a mortgage loan, you used leverage. You put 5% down, financed 95% but got 100% of the benefit of the use of the home before the mortgage is paid off. If home prices hold steady or go up, you're fine. If prices go down by more than 5%, you lost your investment. Leverage helps generate more money in an up market and can quickly become a problem in a down market.
Where do I buy derivatives? Can I buy them like I do stocks?
Derivatives are not traded like stocks are. Stock prices are announced to the public. Compilations of stock prices over the years are readily available from a number of sources. Major market players disclose their purchases. Information about publicly traded companies is required to be disclosed to the public.
None of this is true about derivatives. There is no public market for many derivatives. (The Chicago Board of Trade (CBOT) trades futures and some other derivatives, but not all types of derivatives.) There are no daily compilations of values or moves by major market players. Many derivatives are privately negotiated contracts which are traded privately. Privacy is ok in business transactions until problems occur and the public needs to pay money to clean up the mess caused by the privacy.
Are all derivatives the same?
No, many derivatives are one-off or specially crafted to fit a specific need. This is good because the need for a special financial instrument can be filled. This is bad because no one else may want to buy the special financial instrument. Think of this as the difference between a really nice tract home in Irvine and a custom home in Coto de Caza. The tract home can be easier to sell because there are more people looking for those features (number of rooms, pool & spa, etc.) The custom home in Coto can be a very hard sell, especially if there are unusual custom features (4 bowling alleys, pirate themed pool area, 25 car garage.) The seller would need to find a buyer who wants to specific features in order to sell the home. The same works with derivatives.
One last question - If I want to buy derivatives, who will explain them to me?
In many cases, the company you are buying the derivatives from will "teach you" about their products. If they don't actually do the "training", they hire some one to do the "training." Do you really think the "trainer" is going to give a realistic picture about what can go wrong? If you do, I have a nice house in Coto with a pirate pool, 4 bowling alleys that comes with a contract to buy 5 train cars of potatoes.
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