Derivatives ... and assorted financial accoutrements
I just read about Warren Buffett's last newsletter to Berkshire-Hathaway shareholders where he says that derivatives are "financial weapons of mass destruction"
... and I thought: "What the &%^$#? are derivatives?"

So I browsed and have learned something ...

>Why do you insist upon telling what you've learned? I mean ...
Pay attention.
If you buy shares in some company, you're buying an asset ... and that's a piece of the company.
You can proudly claim, "I own 0.00001% of General Electric".

On the other hand, if you buy a derivative, that's a contract and there are several types.
The company or person who sold you the contract is saying:

  • Warrants and Options
    • "If you pay me $X, I agree to sell you 100 shares of XYZ at $Y per share anytime you want, before such-and-such date"
    • "If you pay me $X, I agree to buy from you 100 shares of XYZ at $Y per share anytime you want, before such-and-such date"

>Wait! They look the same to me!
A warrant is offered by the company itself (example: XYZ company) and often has a lifetime of years whereas Options can be bought and sold by any investor and (usually) have a lifetime measured in months.

Also, a company may, as "sweeteners", offer warrants which say:
"If you buy $100,000 worth of our stock at $10 per share, we'll issue you warrants which allow you to buy an additonal 20% * $100K = $20K worth of stock at $10 per share."

>And that's derivatives?
Not entirely. It gets better.
There are index derivatives where, instead of stock, the outfit which issues the derivative says:
      "If you pay me $X, I agree to pay you $Y if some index falls below 3000 before some_date"

And there are credit derivatives (such as swaps) where the issuer says:
      "I will put up $X to buy stock XYZ and you will pay me interest on that $X and you get to keep all the
      dividends and stock gains, but if the stock decreases in value, you pay me the losses."

>I like that one. I don't have to put up the money, but keep the gains.
And swallow the losses. As Buffett puts it:

"Party A to the contract, usually a bank, puts up all the money for the stock while Party B, without putting up any capital, agrees that at a future date it will receive any gain or pay any loss to the bank that the bank realizes.

Total-return swaps of this type make a joke of margin requirements."

Then there are interest rate swaps and swaptions and commodities derivatives
and derivatives in foreign exchange and pork bellies and, of course, other derivatives ...

Then, various people have various things to say about derivatives:

  • "Derivatives." That's the 11-letter four-letter word.
          Richard Syron, Chairman, American Stock Exchange
  • Derivatives are like NFL quarterbacks. They get too much of the credit and too much of the blame.
          Gerald Corrigan, Goldman Sachs
  • The beauty of derivatives is that they self-destruct every month and you get another commission.
          Don Stone, NYSE specialist
  • Years earlier, as a cashier at McDonald's, I had been trained in the art of "suggestive selling." If a customer ordered a cheeseburger and fries, I knew to ask "Would you like an apple pie with that?" That strategy worked at Morgan Stanley. If a customer ordered a simple treasury bond, you asked "Would you like a leveraged derivative with that?"
          Frank Partnoy, F.I.A.S.C.O.
  • Treat exotic derivatives like powerful medicines, large doses of which can be harmful. Use them in moderation, for a particular purpose (such as risk management) and only after having read the instructions on the bottle.
          Philippe Jorion, "Big Bets Gone Bad"
And then there was Nick Leeson who broke the bank at Barings by trading on the Japanese and Singapore futures exchanges, selling Nikkei put and call options with a nominal value of almost $7 billion (while the bank's reported capital was less than $1 billion; Barings sent over $800 million to meet margin obligations on the Singapore International Monetary Exchange). Then the Nikkei collapsed as an earthquake struck ... the city of Kobe ... and the bank as Leeson tried to catch up by continually increasing his highly margined position:
  • Nick Leeson, whom most of you know and all of you have heard of, runs our operation in Singapore, which I want you all to emulate.
          Ron Baker, Barings
  • The recovery in profitability has been amazing following the reorganization, leaving Barings to conclude that it was actually not all that terribly difficult to make money in the securities business.
          Peter Baring, chairman
  • There is little argument about who was derivatives technology salesman of 1995. Most people agree that Nick Leeson did more than anyone to raise the awareness of the need for firm-wide risk management.
          Clive Davidson , "Profiting from Doom"

>What's the difference between OJ Simpson and Nick Leeson?
I give up.
>OJ knew when to cut his losses.

Uh ... I forgot:

  • Derivatives are weapons of mass destruction
          Warren Buffett

And then there are Hedge Funds (for those few of us with a few $million to invest).
These funds take advantage of the fact that the Securities and Exchange Commission (SEC) doesn't apply the same strict rules as it does to traditional mutual funds. The managers of hedge funds use short selling, futures, leverage, active trading and various derivatives ... with few constraints.

Wall Street trader John Meriwether and his team of PhDs and Nobel prize winners and their hedge fund, Long Term Capital Management (LTCM), collapsed in the late 1990s, nearly sinking the global financial system - they had to be bailed out by Wall Street's biggest banks (with the encouragement of the Federal Reserve).

LTCM bought 29-year treasury bonds and shorted 30-year bonds in order to capitalize on the small spread in yields (the 29-year yields being larger). Being long on the higher yielding and short on the lower yielding bonds, they weren't concerned that the bond market might go up or down, only that the yields would converge (since one would expect the 30-year to have a yield not less than the 29-year). If the yields did converge and the bond market went down, they'd make more on the shorts than they'd lose on the longs. If the market went up they'd make more on the longs than they'd lose on the shorts. It was an (almost) guaranteed money making strategy ... especially as they were highly margined. With $4.8 billion in capital, LTCM controlled $160 billion in stocks and bonds and derivatives with a value of $1 trillion; that's over 200-to-1 !

And did the yields converge? No, the yields drifted apart.
And did LTCM actually put up their 1% or 2% margin? No, the banks did.
Indeed, LTCM was able to borrow 100% of the value of an investment, and with that cash to buy more securities and use that as collateral for further borrowing ... ad infinitum.

>Mamma mia!!
My sentiments exactly.

In 2000 George Soros shut down his Quantum Hedge Fund after sustaining stupendous losses.

See also Derivatives (quotes)