What the Heck is a Derivative?

A derivative is a contract that derives its value from something else. The notional value of a derivative is its face value. It might be simpler to think of it like your homeowners' insurance policy; the policy can pay out up to the stated replacement cost of your house - that is the face value (or notional value) of the insurance policy. If it costs $100,000 to rebuild your house, then the market in homeowners' insurance on your house is $100,000 in notional value. The insurance company doesn't pay $100k, they're simply at risk for up to $100k. The premium you pay to the insurance company each year is the part that gets added to GDP, the part the insurance company can save, spend, or invest, the part that matters in any year that you don't have losses.

But, Hurricane Katrinas can happen. So the insurance company has to set aside enough money to pay out the claims it can reasonably expect. Insurance companies are heavily regulated by State and Federal government agencies, and they are required to use reasonable assumptions to decide how many claims to reasonably expect, and they are required to keep enough money on hand to cover those claims.

Derivatives, on the other hand, are not heavily regulated. In many ways, a derivative is like an insurance policy. If I am worried that my Corning stock might decline in value right when I want to cash it in for a down payment on a house, I can buy a put option contract (one of many types of derivatives) that gives me a right to sell the stock at an agreed-upon price within a specific time period. Effectively, I am insuring against a decline in the value of an important asset (much like you insure against a fire destroying the value of your home).

There are many other types of derivatives contracts, and they cover a wide variety of possible losses. One type of loss they cover is "credit default" - if I lend money to my brother-in-law, I know the odds aren't very good that he'll pay me back. A credit-default "swap" lets me pay somebody else to take on the risk (the other guy pays me if my BIL flakes) - we "swap" a little money in exchange for trading who bears the risk.

You'll note that my Brother-in-Law isn't very likely to pay me back, and I knew that when I lent him money. That's one of the problems with credit-default swaps. Banks made crazy mortgages, and they didn't have any good reason to believe that, say, the Target cashier buying a half-million-dollar house would actually pay the mortgage back. Since the derivatives market is essentially unregulated, you can actually buy the equivalent of a credit-default swap on your deadbeat Brother-in-Law. In real insurance, you can't do that - you can only insure against a risk that neither side could reasonably predict. Letting someone buy insurance after, say, the house burns down, would mean that the only people buying insurance are people whose houses are on fire.

Given the loosey-goosey rules around derivatives contracts, people can use options contracts responsibly and irresponsibly. The only limit is whether you can find someone to trade risk with you. And, mostly, you can - it's like having a group of dumb, fun-loving friends who will actually sell you fire insurance even after finding out you store kerosene next to your woodstove, and you're fixin' to build a fire.

And derivatives traders have something else in common with dumb frat boys. They'll bet on pretty much anything. If you've ever looked at a friend across a bar table and said "I'll bet you $10 she shoots him down," you're qualified to be a derivatives trader. Because derivatives contracts don't require that either side be directly involved in the transaction that the contract derives its value from. I don't have to own Corning stock to buy a put option on Corning, and you don't have to own Corning stock to sell me a put contract. So derivatives contracts can work as side bets - just like that bar bet about whether some guy you don't even know gets a date with some woman you don't even know.

So, that's a very rough description of these derivatives things people are talking about. My next post will provide some wild conjecture about how big the risk is in derivatives trading.