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Private enterprise produces the goods and services we all want, and hires the majority of us as labor to produce those goods and services. It also depends on capital we supply as savings and investments. But the allocation of labor and especially capital between millions of households and hundreds of thousands of private-sector businesses is a vastly complex enterprise. The need to move money around to the right places gives rise to the financial markets and the financial services industry.
The history of the financial markets and the financial services industry is full of success and failure, and as we emerge from the Great Recession, the pendulum has clearly swung from success to failure and back in the direction of success. The financial services industry grew beyond its traditional role as facilitator of the public and private economy into a large part of the economy in and of itself. Newfangled financial instruments and an excessive liberalization of credit served to fill the coffers of the industry to the point where in 2005 the industry made some 40 percent of all profits made by America’s top corporations. This distortion came home to roost in a big way when the resulting real estate bubble popped. It’s enough to make you or anyone else mad, but that energy would be better spent understanding what happened, why, and what should be done to prevent a repeat performance.
As we move forward, the financial industry has retrenched, and new regulation, such as the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (see #39) will likely serve to curb the excesses of the past. That said, most of the markets and instruments of the financial services industry will continue to exist and play an important part in capital allocation and economic growth. What follows takes a look at these important private-sector building blocks of the economy.
66. DERIVATIVES AND DERIVATIVE TRADING
Anybody who’s read even the slightest bit of economic or financial news in the past couple of years has run across the term derivative. Derivatives have been in the news a lot ever since the early days of the 2008–2009 financial crisis.
So what is a derivative, anyway? Simply, it’s a financial contract or asset whose price is determined by the price of something else. Want to buy a thousand barrels of oil as an investment, or to use in your business, or to resell? You can, but you’d have to pay the full price for the oil, perhaps $100,000, and you’d have to find a place to store it. As an alternative, you can buy a derivative based on the price of oil, perhaps a futures contract, specifying delivery of that oil at a future date at a specified price. If the price of oil goes up, the price of your derivative will go up too.
What You Should Know
Derivatives can be based on almost any kind of underlying asset—a physical asset like a commodity, a financial asset like a stock or mortgage or bond or some other debt security, an index like a stock or interest rate or exchange rate index, or just about anything.
There are three primary types of derivatives:
Futures specify the delivery of a fixed amount of something at an established date. Futures are traded on agricultural products, energy, metal, stock indexes, interest rates, currencies, and an assortment of other assets on futures exchanges, and represent relatively large bets on these items (see #80 Commodities, Futures, and Futures Markets). Note that you don’t have to (and most people don’t) wait for the expiration of a futures contract to settle; you can sell or buy it prior to that date based on market prices at the time.
Options are contracts giving the right, but not the obligation, to buy or sell something on or before a future date, usually a stock, but sometimes a futures contract. Equity options are traded on thousands of stocks, and can also be traded on futures contracts; options are relatively smaller investments in size or total outlay, but can be very highly leveraged for large gains (the concept of leverage is described below).
Swaps are a contract to exchange cash on or before a specified date based on the price of a particular asset. They differ from futures in that you don’t actually buy the item; it is a contract simply to settle with cash on or before the settlement date. Additionally, swaps are more of a “one-off” contract custom-made between private parties; they’re not traded as established securities available to the public on a securities exchange. A “credit default swap,” which guarantees payment only in case of a credit default, is a bit different (see #69 Credit Default Swap).
Derivatives can be used to hedge or to speculate. Farmers will hedge against the decline in the price of wheat, for example, by selling a futures contract on what they are producing. That allows them to pocket some cash now, giving some insurance against a price fall, or even a crop failure. On the other side of the trade, a brewery might hedge by buying a futures contract to protect against price increases, or even to guarantee supply in times of shortage.
As a tool to speculate, investors not in the brewing or farming business may also “play” the wheat futures market, betting on a rise or decline in wheat prices based on a host of factors. Derivatives offer leverage. Leverage allows you to enjoy the price gains or suffer the declines of the underlying asset with as little as 5 or 10 percent of the value invested, a key attraction for speculators. You can buy that interest in $100,000 of oil for a tenth of that, but if it goes down, you’ll lose your entire investment, and sometimes more.
Aside from helping farmers and brewers, the existence of derivatives gives investors and financial institutions ways to invest in things, and ways to manage risks. They also help bring more participants to any given market, making that market and its prices more truly reflect supply and demand. However, the broad array of derivatives and the opaque nature of some of the customized derivatives created through “financial engineering” in the last decade have caused considerable trouble. Additionally, derivatives traders overplayed their hands, writing more contracts than they could possibly cover. Forthcoming regulation will likely standardize trading and trading rules for some of the exotic derivatives, particularly swaps (see #69 Credit Default Swap). This will give a more favorable name to these instruments and help them move away from the “financial weapons of mass destruction” moniker assigned by billionaire investor Warren Buffett in 2002.
The size of the world derivatives market is phenomenal, estimated at some $1,200 trillion face or nominal value (although some estimates claim it to be higher). To put that figure in perspective, it is about twenty times the size of the entire global economy.
Why You Should Care
With so much bad news circulating about derivatives, it’s a good idea to understand what they are, and know how they can cause trouble. That said, certain derivatives like stock options can actually be used to reduce your risk—that is, to hedge on your stocks. That can make a lot of sense for ordinary investors who know what they’re doing.
67. ASSET-BACKED SECURITY
Asset-backed securities (ABSs) were once a dark corner of the financial world, a financial tool most people wouldn’t commonly know or care about. But the 2008–2009 financial crisis put ABSs center stage, particularly the real estate versions known as mortgage-backed securities (MBSs) and so-called collateralized debt obligations (CDOs) (see #68). For the most part, ABSs aren’t consumer products—they are bought and sold by large financial institutions—but in the interest of understanding the financial news, and understanding how “engineered” financial products like this can affect you, read on.