What exactly are derivatives?
The term for the complicated investment instrument is front in center when it comes to explaining and addressing the current credit crisis.
We spoke with Martin Evans, a Professor of Finance and Economics at Georgetown University (www.gwu.edu).
What are derivatives?
They’re really just a particular type of financial asset whose value can vary dramatically according to the price of another underlying asset that determines the derivative's payout. For example, an option is worth nothing unless the price of the underlined stock moves to a certain point. After that point it becomes valuable because it gives the owner of the option the ability to make a profitable trade in the underlying stock.
The term derivative comes from the fact that the value of the assets is derived from the price of another financial asset. Insurance is a form of a derivative.
What types of derivatives are there?
Derivatives exist for stocks, bonds and foreign exchange. Some are traded on exchanges while others trade bilaterally between individual financial institutions. Credit default swaps are an example of a type of derivative that does not trade on a centralized market. Derivates can be used to bet on the future movements in stocks prices, interest rates, or exchange rates. They can also be used as a form of insurance.
Example: If Fannie Mae supplied mortgages to a bunch of high risk borrowers, they could bundle the mortgages and sell them off to other institutions. The other institution might question the credit worthiness of the bundle and question possible defaults. In response, Fannie Mae would also sell them an insurance policy, in the form of a derivative that is dependent on the default of the mortgage. The price the financial institution pays for the derivate represents the premium on the insurance policy.
Can I buy derivatives?
You can go to online brokerage and buy options on bonds and stocks, but the derivatives being addressed in the press, such as credit default swaps, are only traded between big financial institutions.