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Marketing to Derivatives Leaders in Investment Banking

Understanding Their Role

Most financial assets have a clearly defined value. If an investor owns a $100 bond, they know the issuer will give them exactly $100 when the bond matures. An investor that possesses 5% of a company’s stock knows that they own exactly 5% of the company’s total value. A derivative is a financial asset that differs from other financial assets in that a derivative has no inherent value. This is because the value of a derivative is “derived” from the behavior or performance of other assets (such as stocks or commodities). Generally speaking, a derivative is a contract between two or more parties that specifies conditions under which payments are made between the participants.

 

Since derivatives cover such a broad and vague range of financial instruments, the concept can be confusing even for investors. Therefore it is often helpful to look at examples of common derivatives to understand how they work and how they benefit investors. Derivatives are mainly used for two purposes- speculation and protection against risk (known as “hedging”)

 

One way to speculate in the stock market is to purchase a financial derivative know as a “warrant”. A warrant contract gives an investor the right (but not the obligation) to purchase a stock in the future at an agreed upon price called the “strike price”. The warrant contract has an expiration date, often 5 or 10 years. For example, a tech company’s stock is currently trading for $20, but an investor thinks the value will go way up in the future. The investor buys a 10 year warrant for $2 with a “strike price” of $40. After 10 years:

 

  • If the stock price is $80 the investor uses the warrant to buy the stock for $40-they immediately sell it for $80, making a $40 profit (minus the $2 they paid for the warrant)
  • If the stock price is $40 the warrant is worthless because any investor could buy the stock at this price even if they didn’t have a warrant
  • If the stock price plummets to $5 the investor does not suffer big losses like the people that actually own the stock - they’re only out the $2 they paid for the warrant. Therefore warrants allow investors to speculate that a stock price will spike, while protecting them from big losses if the stuck value actually plummets.

 

Futures Contracts are one of the most common types of hedge derivatives. Let’s say a jewelry manufacturer buys a lot of gold to make their products, and they fear that gold prices will rise in the next year. One option is to buy all of the gold they will need for the next 12 months. But this would tie up a lot of capital, and the jeweler would lose a lot of money if the price of gold actually went down. Instead the jeweler could enter into a 12 month gold futures contract in which they agree to pay a pre-determined price for gold over the next 12 months. There are always two parties in a futures contract:

 

  • The “long position” represents the buyer who is obligated to take physical possession of the commodity
  • The “short position” represents the seller who has the obligation to make delivery of the commodity

 

Another common example is a Credit Derivative, where someone who has issued a lot of loans sells the outstanding balance of these loans to another party at a discount. An example would be a used car dealership that has sold 100 cars, and the people that bought the cars owe the dealership a total of $1 million in payments. The dealership could bundle all these loans into a credit derivative and sell these loans to a 3 rd party for $925k. The party that buys the derivative has the potential to make a $75k profit if all the car owners pay their loans in full. The car dealer has the benefit of receiving a large infusion of capital they can use to buy new inventory, and they no longer have to worry about one of the car owners defaulting on their loan.

 

A sub-category of credit derivatives is the Mortgage Backed Security, where home lenders sell the mortgages they hold to financial investors. These Mortgage Backed Securities were in the news a lot during the financial crisis of 2008. When housing prices fell, many homeowners defaulted on their mortgages, which decimated the value of these derivatives. This led to a “chain-reaction” which caused a liquidity crisis for some of the country’s largest financial institutions. Congress addressed this problem by passing the Dodd Frank Act, which imposed new regulations on financial markets. Specifically, the Dodd Frank Act directed the Commodity Futures Trading Commission (CFTC or commission) and Securities and Exchange Commission (SEC) to write a variety of rules to reduce the systemic risks presented by the derivatives markets and to increase the transparency of those markets.1

“Because areas of complex valuation, such as these, require the exercise of judgment, they also necessitate strong internal accounting controls in order to arrive at reasonable valuations for financial reporting purposes….”

– SEC order to Deutsche Bank2

1 Berkovitz, Dan M. “Swaps Provisions of Dodd-Frank Act: Cost-Benefit Analysis and Judicial Review.” Banking & Financial Services Policy Report 33, no. 9 (2014): 1 – 16. EBSCOhost(98361029).

2 Goldstein, Matthew. “Deutsche Bank to Pay $55 Million to Settle Derivatives Inquiry.” The New York Times. May 2015. Accessed 11/25/15, available at: www.nytimes.com/2015/05/27/business/dealbook/sec-says-deutsche-bank-misvalued-derivatives.html

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Derivatives are sophisticated financial contracts with values that are “derived” from movements in the price of other assets. Derivatives have many uses, including protecting investors from unexpected changes in the market and allowing investors to additional ways to speculate on anticipated changes.
fusion point research Marketing Research Reports
Derivatives are sophisticated financial contracts with values that are “derived” from movements in the price of other assets. Derivatives have many uses, including protecting investors from unexpected changes in the market and allowing investors to additional ways to speculate on anticipated changes.
  • If the stock price is $80 the investor uses the warrant to buy the stock for $40-they immediately sell it for $80, making a $40 profit (minus the $2 they paid for the warrant)
  • If the stock price is $40 the warrant is worthless because any investor could buy the stock at this price even if they didn’t have a warrant
  • If the stock price plummets to $5 the investor does not suffer big losses like the people that actually own the stock - they’re only out the $2 they paid for the warrant. Therefore warrants allow investors to speculate that a stock price will spike, while protecting them from big losses if the stuck value actually plummets.
  • The “long position” represents the buyer who is obligated to take physical possession of the commodity
  • The “short position” represents the seller who has the obligation to make delivery of the commodity