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What is a "Derivative" anyway?

V

VegasGuy

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OG Investor
Maybe some of you finance and or accounting experts already know what a derivative is but for the rest, what in the hezell is a derivative?

According to Wiki:
Derivatives are financial contracts, or financial instruments, whose values are derived from the value of something else (known as the underlying).

The underlying on which a derivative is based can be an asset (e.g., commodities, equities (stocks), residential mortgages, commercial real estate, loans, bonds), an index (e.g., interest rates, exchange rates, stock market indices, consumer price index (CPI) — see inflation derivatives), or other items (e.g., weather conditions, or other derivatives). Credit derivatives are based on loans, bonds or other forms of credit.

The main types of derivatives are forwards, futures, options, and swaps.

Derivatives can be used to mitigate the risk of economic loss arising from changes in the value of the underlying. This activity is known as hedging.

Alternatively, derivatives can be used by investors to increase the profit arising if the value of the underlying moves in the direction they expect. This activity is known as speculation.

Because the value of a derivative is contingent on the value of the underlying, the notional value of derivatives is recorded off the balance sheet of an institution, although the market value of derivatives is recorded on the balance sheet.
Click to expand...

Make sense?
Of course it makes no sense. That's why we are in the fix we in today because it doesn't make sense and most people only look at the bottom line, "how much money can I make?" They don't look at the underpinnings of what this shit is because it's a lot of double talk and accounting language.

But let me try to break up some of this bullshit into smaller pieces and see if I understand Wiki. Finance heads feel free to jump in.

First of all the word itself: derivative. From the word "derive". As in to deduce, to obtain from, to evolve out of. i.e. The product items with inherent value would be made a derivative.

For example. Let's take your net worth...take all the shit you own, your car, your watches, rings, porn stash, weed stash, houses, boats, guns, hoes if you own 'em and come up with a dollar value for all of it. Lets pick a number, say $100,000.00 for all your shit. This is your net worth and what you'll use as bargaining chips. Simply stated this is a underlying of a derivative because it is the product that evolves out of the stuff you own. This is the instrument (contract) you'll use like real money to buy and sell in the markets. Still with me?

Moving on...

Now you craft a contract and list the value of all your stuff as collateral. Your collateral (net worth) is what props up, supports, or as they call it the "underlying" of your contract or derivative. It is the same as the $100,000.00 worth of stuff you own.

Now lets say you want to purchase a Lear that costs 250,000.00. You ain't got 250k in cash but you have your derivative and Lear guy takes and some cash that but you still owe the Lear dude 100k. In order to pay Lear dude, you have to borrow from the bank. Bank says, "what you got to back up the loan big pimpin'?"

I got a derivative of a porn stash, weed stash, 6 hoes and this Lear.

learjet.jpg


Bank manager says, "shit you ballin'. Here is 100k but you owe us 110k and I need two a dem hoes by the house by 6:00." DEAL.

Lear dude gets half now 50k and you burn through the other 50k like Madoff.

Here is the rub. Derivatives change over time. The value contained in it or the underlying either increase or decrease in value. One of your hoes gets pregnant, your house burns to the ground and your weed stash was in there. That means somebody got to pick up the slack for those changes. Usually that person is you. But for the sake of discussion, the underlying isn't what it was when you started.

Get thousands of people doing this and pulling folks in and eventually, real money got to show up and be paid. So that's where all the creative financing to purchase a home began to show up -- selling houses to people least able to afford it. But they have to get that money from somewhere and talked you into signing your name.

Lear Jet dude ain't no pawn shop and wants his money. He can't spend a derivative on his bills, he needs $200k in cash plus interest. Bank dude ain't no pawn shop either and wants his money, and he claims the baby your hoe got ain't his. He lent real money for shit he doesn't need and can't spend.

The head fake in all this is, the derivatives show up on the books but the underlying shit does not.

This is the mess deregulation by Reagan his democratic lackeys and the republican party put us in.

Hope this helps.

-VG
 
In layman's words a derivative is like a side bet, that you can make for or against movement in the market. For example you can make one that the price of gold would increase, or decrease, you can make one on a stock, with out actually owning the stock. The problem is when lending institutions started making derivative "bets" against the mortgages they were handing out, it gave them incentive to give out shaky mortgages, that they know would go into foreclosure. Derivatives were illegal for almost a 100 years, due to them almost collapsing the economy back then, but Greenspan convinced Clinton to pass the bill to make it legal again, and look what happen.
roadragecopy-2.jpg
 
A simple way of explaining a derivative:
It's like betting on the outcome of a basketball game.
You don't play for either team. You don't own either team or any portion of them.

But the bet says if you win, you win Money.
But if you lose, you lose your money.

I never fully understood them (or rather how they make money since you don't own ANYTHING), so I stayed the FUCK AWAY from them when my investment guy tried to get me into some.
I thought I was safe by not buying them....
Jokes on me, I still got burnt by them because EVERYONE was rigging the game with them and CDOs and CDSs.


Derivatives used to go by another name back in the early 1900's ... BUCKET SHOPS. Look up the term and learn. They were outlawed. Cannot believe we made the same fucking mistakes.
 
'preciate the post, playa but you made that harder than it needed to be.


A derivative is basically an insturment that, by itself, has no intrinsic value, but based on an asset that does.

Here's an example I live everyday:

I think the price of oil is going to go up in the future, so I buy an oil futures contract (a derivative). The contract itself doesnt really have any value, but the oil it entitles me to does. If the price of that oil goes up I can sell that futures contract for a profit and make real money, or if goes down, I lose real money. At no point in time did a single drop of oil ever change hands.

Eventually, there will come a time that somebody has to take delivery of 42,000 gallons (1000 barrels) of oil. This is known as delivery (or settlement). But during that time prior to delivery, there has been 1000s of contracts traded against those 1000 barrels.

Time comes for somebody to pay, and if there is no one to pay, then thats when all hell breaks loose. Which is what you are seeing in the credit and debt markets.:eek:
 
Heist said:
A simple way of explaining a derivative:
It's like betting on the outcome of a basketball game.
You don't play for either team. You don't own either team or any portion of them.

But the bet says if you win, you win Money.
But if you lose, you lose your money.

I never fully understood them (or rather how they make money since you don't own ANYTHING), so I stayed the FUCK AWAY from them when my investment guy tried to get me into some.
I thought I was safe by not buying them....
Jokes on me, I still got burnt by them because EVERYONE was rigging the game with them and CDOs and CDSs.


Derivatives used to go by another name back in the early 1900's ... BUCKET SHOPS. Look up the term and learn. They were outlawed. Cannot believe we made the same fucking mistakes.
Click to expand...

Actually, a bucket shop is a slightly different racket. While they do create a sort of derivative with how they do business with you, they arent considered an actual derivative product. A modern day bucket shop are all these forex brokers that advertise all over the place.
 
DuhDuhMan said:
'preciate the post, playa but you made that harder than it needed to be.


A derivative is basically an insturment that, by itself, has no intrinsic value, but based on an asset that does.

Here's an example I live everyday:

I think the price of oil is going to go up in the future, so I buy an oil futures contract (a derivative). The contract itself doesnt really have any value, but the oil it entitles me to does. If the price of that oil goes up I can sell that futures contract for a profit and make real money, or if goes down, I lose real money. At no point in time did a single drop of oil ever change hands.

Eventually, there will come a time that somebody has to take delivery of 42,000 gallons (1000 barrels) of oil. This is known as delivery (or settlement). But during that time prior to delivery, there has been 1000s of contracts traded against those 1000 barrels.

Time comes for somebody to pay, and if there is no one to pay, then thats when all hell breaks loose. Which is what you are seeing in the credit and debt markets.:eek:
Click to expand...

Thank you, because both wiki and the OP were confusing me.
 
DuhDuhMan said:
Actually, a bucket shop is a slightly different racket. While they do create a sort of derivative with how they do business with you, they arent considered an actual derivative product. A modern day bucket shop are all these forex brokers that advertise all over the place.
Click to expand...

I'm talking about the old bucket shops. The actual shops that were nothing more than exchange gambling shops. They had no affiliation with the legitimate Finance industry.
There were tons of them in NYC during the early 1900's. Really nasty shit. :smh:

In the United States, the traditional pseudo-brokerage bucket shops came under increasing legal assault in the early 1900s, and were effectively eliminated in the 1920s. However, the term came to apply to other types of scams, some of which are still practiced. They were typically small store front operations that catered to the small investor, where speculators could bet on price fluctuations during market hours. However, no actual shares were bought or sold: all trading was between the bucket shop and its clients. The bucket shop made its profit from commissions, and also profited when share prices fell.

The terms of trade were different for each bucket shop, but bucket shops typically catered to customers who traded on thin margins, even as low as 1%. Most bucket shops refused to make margin calls, so that if the stock price fell even momentarily to the limit of the client's margin, the client would lose his entire investment

The highly leveraged use of margins theoretically gave the speculators equally large upside potential. However, if a bucket shop held a large position on a stock, it might sell the stock on the real stock exchange, causing the price on the ticker tape to momentarily move down enough to wipe out its client's margins, and the bucket shop could take 100% of their investments.[7]
Click to expand...
 
DuhDuhMan said:
'preciate the post, playa but you made that harder than it needed to be.


A derivative is basically an insturment that, by itself, has no intrinsic value, but based on an asset that does.

Here's an example I live everyday:

I think the price of oil is going to go up in the future, so I buy an oil futures contract (a derivative). The contract itself doesnt really have any value, but the oil it entitles me to does. If the price of that oil goes up I can sell that futures contract for a profit and make real money, or if goes down, I lose real money. At no point in time did a single drop of oil ever change hands.

Eventually, there will come a time that somebody has to take delivery of 42,000 gallons (1000 barrels) of oil. This is known as delivery (or settlement). But during that time prior to delivery, there has been 1000s of contracts traded against those 1000 barrels.

Time comes for somebody to pay, and if there is no one to pay, then thats when all hell breaks loose. Which is what you are seeing in the credit and debt markets.:eek:
Click to expand...

But are you not talking about hedging and speculation of those derivatives? I was trying to get at what a derivative is, even though my explanation might have missed the intended mark. But thanks for jumping in because I'm trying to understand this.

-VG
 
VegasGuy said:
But are you not talking about hedging and speculation of those derivatives? I was trying to get at what a derivative is, even though my explanation might have missed the intended mark. But thanks for jumping in because I'm trying to understand this.

-VG
Click to expand...

Yes and no.

Yes, the fact that there are secondary markets made around the product itself, leads to speculation and hedging.

No, in that fact that the actual product traded (the contract) is an actual derivative.

I see where you was going with your example but you added more than what a true derivative is. That's a prime example of what is known as "financial engineering". Basically, in your example you had a derivative product and a derivative of the derivative (2nd order derivative). You were illustrating what those cats who were labeled "masters of the universe" was doing.:eek:

After a while, they had concocted 4th and 5th order derivatives, and no one knew what was or how to value the underlying asset. And then it all went to shit.:hmm:
 
DuhDuhMan said:
Yes and no.

Yes, the fact that there are secondary markets made around the product itself, leads to speculation and hedging.

No, in that fact that the actual product traded (the contract) is an actual derivative.

I see where you was going with your example but you added more than what a true derivative is. That's a prime example of what is known as "financial engineering". Basically, in your example you had a derivative product and a derivative of the derivative (2nd order derivative). You were illustrating what those cats who were labeled "masters of the universe" was doing.:eek:

After a while, they had concocted 4th and 5th order derivatives, and no one knew what was or how to value the underlying asset. And then it all went to shit.:hmm:
Click to expand...

Ahhh, ok. A derivative of a derivative? When the Lear was purchased or before? If I understand the Wiki explanation, my guess would be when the Lear was purchased would be that financial engineering thing. Yes, no?

-VG
 
this derivative is some bullshit.

It's like I am picturing myself fucking this the women I see in BGOL, so I am really fucking these women but I am not cause it is not there but my hand.
 
VegasGuy said:
Ahhh, ok. A derivative of a derivative? When the Lear was purchased or before? If I understand the Wiki explanation, my guess would be when the Lear was purchased would be that financial engineering thing. Yes, no?

-VG
Click to expand...

Youre on the right track now. The first time you packaged all your assets, valued it at 100k and negotiated that instrument, that was your first order derivative product.

Then when you got the LearJet, re-packaged it into your bundle of assets and negotiated the bank loan, you were offering up a second-order derivative. It's second order because you were using the value in the original 100k package of assets to create value in another instrument (the LearJet package) that you presented to the bank. You just performed "Financial Engineering"

Now, the bank cant really accurately value what youve presented beacuse they dont have visibility into the original derivative's asset package (house, car, boats, etc). All they see is the weed, hoes and the LearJet. This is how a lot of people got caught out there.

Using your illustration, when the house burned down and the hoes got preggers, everything that was being valued on those assets are now worthless, and the dominoes start to fall...

This is what happened when they bundled suspect mortgages in with soverign credit notes and other risk saturated products. No one knew what shit was worth and the real dollars stopped flowing in.
 
Why did you need to insult with the "hoe talk" nigga.................

What bank is gonna lend anyone money who uses hoes, and weed as collateral? Who are you really trying to relate to your point?
 
DuhDuhMan said:
Yes and no.

Yes, the fact that there are secondary markets made around the product itself, leads to speculation and hedging.

No, in that fact that the actual product traded (the contract) is an actual derivative.

I see where you was going with your example but you added more than what a true derivative is. That's a prime example of what is known as "financial engineering". Basically, in your example you had a derivative product and a derivative of the derivative (2nd order derivative). You were illustrating what those cats who were labeled "masters of the universe" was doing.:eek:

After a while, they had concocted 4th and 5th order derivatives, and no one knew what was or how to value the underlying asset. And then it all went to shit.:hmm:
Click to expand...

These would be the CDO's.
 
DuhDuhMan said:
'preciate the post, playa but you made that harder than it needed to be.


A derivative is basically an insturment that, by itself, has no intrinsic value, but based on an asset that does.

Here's an example I live everyday:

I think the price of oil is going to go up in the future, so I buy an oil futures contract (a derivative). The contract itself doesnt really have any value, but the oil it entitles me to does. If the price of that oil goes up I can sell that futures contract for a profit and make real money, or if goes down, I lose real money. At no point in time did a single drop of oil ever change hands.

Eventually, there will come a time that somebody has to take delivery of 42,000 gallons (1000 barrels) of oil. This is known as delivery (or settlement). But during that time prior to delivery, there has been 1000s of contracts traded against those 1000 barrels.

Time comes for somebody to pay, and if there is no one to pay, then thats when all hell breaks loose. Which is what you are seeing in the credit and debt markets.:eek:
Click to expand...

this is the best definition of it. it is a futures contract. the shit is basically some bullshit that is soooo retarded and hard to understand that normal investors are getting killed by them.

enron actually had started buying futures in the weather. THE FUCKING WEATHER. i dont eve understand how you buy futures in the weather but they did it.

now the futures in oil makes sense because what you are doing is entering into a contract to buy something later at a specified price. so later when oil costs $120 a barrel, you still have your futures contract that allows you to by at $65 a barrel. so then you either sell the whole contract for a lump sum or you buy up all the oil you can at $65 and then resell yourself at $120


i am studying to take the CPA exam as we speak and this shit is the tip of the iceberg when it comes to confusing financing and trading.
 
DuhDuhMan said:
Youre on the right track now. The first time you packaged all your assets, valued it at 100k and negotiated that instrument, that was your first order derivative product.

Then when you got the LearJet, re-packaged it into your bundle of assets and negotiated the bank loan, you were offering up a second-order derivative. It's second order because you were using the value in the original 100k package of assets to create value in another instrument (the LearJet package) that you presented to the bank. You just performed "Financial Engineering"

Now, the bank cant really accurately value what youve presented beacuse they dont have visibility into the original derivative's asset package (house, car, boats, etc). All they see is the weed, hoes and the LearJet. This is how a lot of people got caught out there.

Using your illustration, when the house burned down and the hoes got preggers, everything that was being valued on those assets are now worthless, and the dominoes start to fall...

This is what happened when they bundled suspect mortgages in with soverign credit notes and other risk saturated products. No one knew what shit was worth and the real dollars stopped flowing in.
Click to expand...

Is this when mark to market fucked up the game plan?
 
glen107wood said:
this is the best definition of it. it is a futures contract. the shit is basically some bullshit that is soooo retarded and hard to understand that normal investors are getting killed by them.

enron actually had started buying futures in the weather. THE FUCKING WEATHER. i dont eve understand how you buy futures in the weather but they did it.

now the futures in oil makes sense because what you are doing is entering into a contract to buy something later at a specified price. so later when oil costs $120 a barrel, you still have your futures contract that allows you to by at $65 a barrel. so then you either sell the whole contract for a lump sum or you buy up all the oil you can at $65 and then resell yourself at $120


i am studying to take the CPA exam as we speak and this shit is the tip of the iceberg when it comes to confusing financing and trading.
Click to expand...

That's why we need finance heads to explain to the rest of us before we get caught up.

-VG
 
ODUB said:
Is this when mark to market fucked up the game plan?
Click to expand...

mark to market is some other shit that enron used to kill itself.

they would contract some builders to build a power plant or something and the builders would break ground. then they would capitalize the value of the completed power plant even though it was just a foundation.

there was one power plant in europe that they didnt even complete and still kept the value of a completed power plant on the books as an asset.

mark to market is like they would "mark" on the contract then show the "market" the value of shit even though it is not finished
 
VegasGuy said:
That's why we need finance heads to explain to the rest of us before we get caught up.

-VG
Click to expand...

well things like derivatives and mark to market were illegal for the longest. then greenspan came and changed the game. greenspan was heralded as this financial genius but what he was really doing was being short sighted and running the economy for the quick buck.

he even came out and said a couple years ago (like 2 years after bernake took over) that he was wrong with a lot of his decisions and that they were not necessarily best for the future.

there definitely needs to be more regulation with regard to overly confusing shit like this.

i mean, how the fuck are you going to sell futures on the weather.

really i think that all speculation should be highly regulated. alot of times the speculation itself is the only thing driving the market. hell that is what happened with the absurd rise in oil prices from like 2002 to 2006. speculators said it would rise so people traded accordingly and the inevitable happened
 
ODUB said:
Is this when mark to market fucked up the game plan?
Click to expand...

Sort of. Mark to Market says you value your asset at what it would sell for on the open market. So originally when "banks" had all of these MBS (mortgage back securities) loans on their balance sheets they were worth much more because people weren't defaulting on their mortgages

When the real estate market popped, and home values began to sink, and ARM's started to reset and people couldn't pay the increased mortgage and couldn't re-finance, they then started to default on their payments. This meant the loan values on the banks balance sheets were now worth less on the open market, cuz no one want's to pay full price for loans they feel aren't worth it because there are too many loan defaults.

So now, the market value of these loans are shit, and marking them to market means you shrink the size of your balance sheet, and your company is no longer as valuable as it was.
 
glen107wood said:
well things like derivatives and mark to market were illegal for the longest. then greenspan came and changed the game. greenspan was heralded as this financial genius but what he was really doing was being short sighted and running the economy for the quick buck.

he even came out and said a couple years ago (like 2 years after bernake took over) that he was wrong with a lot of his decisions and that they were not necessarily best for the future.

there definitely needs to be more regulation with regard to overly confusing shit like this.

i mean, how the fuck are you going to sell futures on the weather.

really i think that all speculation should be highly regulated. alot of times the speculation itself is the only thing driving the market. hell that is what happened with the absurd rise in oil prices from like 2002 to 2006. speculators said it would rise so people traded accordingly and the inevitable happened
Click to expand...

Agreed.

Futures on the weather? I've heard of the naming stars scam but nothing like weather futures.

-VG
 
Mark to market in and of itself is not bad. For instance, at the end of the trading day, the brokerage firm marks my trades and deposits or deducts my profit or loss. Work today, paid today.

The problem with MtM comes in when who is doing the marking and what the market is isnt clearly defined.
 
DuhDuhMan said:
'preciate the post, playa but you made that harder than it needed to be.


A derivative is basically an insturment that, by itself, has no intrinsic value, but based on an asset that does.

Here's an example I live everyday:

I think the price of oil is going to go up in the future, so I buy an oil futures contract (a derivative). The contract itself doesnt really have any value, but the oil it entitles me to does. If the price of that oil goes up I can sell that futures contract for a profit and make real money, or if goes down, I lose real money. At no point in time did a single drop of oil ever change hands.

Eventually, there will come a time that somebody has to take delivery of 42,000 gallons (1000 barrels) of oil. This is known as delivery (or settlement). But during that time prior to delivery, there has been 1000s of contracts traded against those 1000 barrels.

Time comes for somebody to pay, and if there is no one to pay, then that's when all hell breaks loose. Which is what you are seeing in the credit and debt markets.:eek:
Click to expand...

You getting there, but let me add to it.

You have end buyer, and seller. The seller issue to broker in form of Proof Of Product (POP) priced at today's value for 1000 barrels of oil. The contract is either a "spot deal" or 1- Xyrs contract.

1. Spot deal: broker or clearinghouse have a contract for delivery 12,000 barrels of oil in one year to end buyer(refinery), price at $75.00 per barrel. Each month they have to sell 1000 barrels but now market is at $50.00. So they will buy a spot deal at $50.00 per barrel and swapped the allocation value thus pocketing $25.00. They still have contract obligations at $75.00 per barrel to the seller .
They can hope price over $75.00 to sell the 1000 barrels. if not, they are in trouble.

2. Buy a future contract at today market, $50.00 and swapped the entire allocation of 12,000 barrels.


They also can hope price over $75.00 to sell the 1000 barrels. if not, they are in trouble.

NOW Derivative buyers comes in... think price will increase in x numbers of yrs. They own no product but a piece of paper stating " we have an allocation" with number(contract). They will trade/swap this paper until the contract expires.

Note allocation could be broken into smaller lots. A contract may pass to x number of buyers before it is actually delivered.
The contract could be passed to more than 4 buyers swapping allocation in 24hrs.
 

Harbinger.
Take you avatar, turn it 90 degrees to the right, take a look and tell me what you see!!

LMAO!
 
All in all, derivatives arent a bad thing. The problems come in when every tom dick and harry was creating instruments and bundling loads of non-standardized assets & securities in them. Then the derivative holder was allowed to mark the instrument, not an exchange or an orderly market.

This enabled all the bullshit of overpricing instruments with worthless, low quality underlyings. This was fine as long as you could find the next sucker to keep funding the sham. Allowing banks and brokerages to price thier own instruments is like having the fox guard the henhouse.
 

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