X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2017 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
The devil is in derivative! - Views on News from Equitymaster
 
 
  • PRINT
  • E-MAIL
  • FEEDBACK
  • A  A  A
  • Sep 21, 2006

    The devil is in derivative!

    Yesterday, the financial world was jolted by news of a big hedge fund, which lost more than US$ 3.5 bn in a gas futures contract. While the news did not get as much media attention as the 1998 debacle of the LTCM hedge fund where it had Nobel Prize winners on its rolls, it nonetheless highlights the danger of dealing with financial instruments such as futures or more generally derivatives.

    Mind you, these were not the only cases of misuse of such instruments and the subsequent nasty outcomes. Prominent debacles include the 1994 bankruptcy of Orange County, one of California's richest, due to investments in some ultra-sophisticated derivatives and the 1995 failure of the 200-year old Barings Bank as a result of unauthorized futures and options trading by a rogue employee. Besides, the fear of a lot more financial institutions losing their shirts owing to such leveraged positions continues to loom large.

    Infact, this is what Warren Buffett, widely acknowledged as one of the shrewdest investors ever, had said about derivatives in Berkshire Hathaway's 2002 annual report.

    "The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. [They] are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

    And Buffett is not alone in deriding derivatives; a lot of other value investors share his views. One would now ask 'What is it that make these instruments so risky?' The answer lies in the fact that derivatives are financial instruments that have no intrinsic value but derive their value from something else. They are mainly utilised for hedging the risk of owning things that are subject to unexpected price fluctuations e.g. foreign currencies, food grains, commodities and even equities.

    Let us take an example to clarify things further. Consider the case of Mr. Chandar. He is a farmer and is certain that he can harvest 20 tons of rice. Currently, rice is trading at Rs 5 per kg. At current price levels, he will earn Rs 100,000 that will cover his yearly expenses. But he knows that if there were a bumper crop of rice all over the state, he would be forced to sell his rice at as little as Rs 2 per kg. In that case, he would fall short to meet the expenses.

    So Chandar goes to the local rice merchant, Thakur, and enters into an agreement that three months hence, he will sell his twenty tons of rice to him at the rate of Rs 5 per kg. Now, our Thakur is not a simpleton and knows that three months hence, all the farmers would be selling their produce, and the rates that would be then would be about 15% to 20% lower than what it is now. So, Thakur offers to buy the rice at the price of Rs 4.2 per kg.

    At this, Chandar argues that it is equally likely that in event of a poor crop, the price of rice may be higher than what it is now. Thakur and Chandar finally agree to a price of Rs 5 per kg of rice for 20,000 kgs to be delivered at Thakur's shop after three months.

    This is what we know as the most primitive kind of a derivative contract. Such contracts are called "Forwards" (or a Forward Contract) and is one of the simplest type of a derivative contract. In order to cater to a large number of Chandars and Thakurs and to make sure that both the parties honour their commitments, boards or exchanges have been set up across the world which oversee derivative contracts in virtually every commodity and financial security.

    So far so good! So long as the purpose of such contracts is to hedge against a possible fall or rise in prices, derivatives can prove to be an extremely useful tool. However, if speculators board the bus to benefit from the discrepancy in prices, then we might have huge problems in our hands. Speculators have no other interest apart from making bucks by benefiting from the gyration in prices. They just hope that the seller is wrong temporarily so that they can sell the contract at a higher price to some other guy and profit from the same. It is when these bets go wrong, hedge funds like Amaranth or LTCM, which use ultra-leveraged money to invest in such kind of contracts, vanish without a trace thus eroding considerable amount of wealth in the process.

    These short-term contracts go against the very grain of value investing, which is based on principles that 'existence of value in the absence of assets' and 'predicting short-term price movements' can both prove to be a risky proposition. No wonder, it does not find a place in the investing world of value investors. As long as the purpose is to hedge against price fluctuation of some underlying asset, then the use is justified but if it is used as a source to earn quick money, then we might be in for some nasty surprises.

    In these turbulent times in the Indian market, a lot of investors might be tempted to use such instruments in view of the fear that since it has run up quite a bit in the recent past, a correction is long overdue. Hence, any further purchase of equity should be hedged against a possible fall in order to minimise the damage. There is little wrong in this approach except for the fact that if it is being used for quick money making then be prepared to watch your hard earned money go down the drain. Infact, given its inherent risks, try and avoid it altogether. Happy investing!

     

     

    Equitymaster requests your view! Post a comment on "The devil is in derivative!". Click here!

      
     

    More Views on News

    How to Ride Alongside India's Best Fund Managers (The 5 Minute Wrapup)

    Jun 10, 2017

    Forty Indian investing gurus, as worthy of imitation as the legendary Peter Lynch, can help you get rich in the stock market.

    You've Heard of Timeless Books... Ever Heard of Timeless Stocks? (The 5 Minute Wrapup)

    Aug 19, 2017

    Ever heard of Lindy Effect? Find out how you can use it to pick timeless stocks.

    Why NOW Is the WORST Time for Index Investing (The 5 Minute Wrapup)

    Aug 18, 2017

    Buying the index now will hardly help make money in stocks even in ten years.

    Trump Takes a Beating (Vivek Kaul's Diary)

    Aug 18, 2017

    Donald J Trump, a wrasslin' fan, took a 'Holy Sh*t!' blow on Tuesday.

    How To Read Your Mutual Fund Account Statement Correctly (Outside View)

    Aug 17, 2017

    PersonalFN simplifies the mutual fund account statement for you.

    More Views on News

    Most Popular

    Demonetisation Barely Made Any Difference to Tax Collections(Vivek Kaul's Diary)

    Aug 7, 2017

    The data tells us quite a different story from the one the government is trying to project.

    A 'Backdoor' to Multibaggers: It's Like Investing in Asian Paints Ten Years Ago(The 5 Minute Wrapup)

    Aug 10, 2017

    Don't miss these proxy bets on growing companies or in a few years you will be looking back with regret.

    Should You Invest In Bharat-22 ETF? Know Here...(Outside View)

    Aug 8, 2017

    Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...

    Signs of Life in the India VIX(Daily Profit Hunter)

    Aug 12, 2017

    The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.

    7 Financial Gifts For Your Sister This Raksha Bandhan(Outside View)

    Aug 7, 2017

    Raksha Bandhan signifies the brother-sister bond. Here are 7 thoughtful financial gifts for sisters...

    More
    Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
    Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement.

    LEGAL DISCLAIMER: Equitymaster Agora Research Private Limited (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA or Canada, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here. The performance data quoted represents past performance and does not guarantee future results.

    SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.

    Equitymaster Agora Research Private Limited. 103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
    Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: info@equitymaster.com. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407
     

    Become A Smarter Investor In
    Just 5 Minutes

    Multibagger Stocks Guide 2017
    Get our special report, Multibagger Stocks Guide (2017 Edition) Now!
    We will never sell or rent your email id.
    Please read our Terms

    S&P BSE SENSEX


    Aug 18, 2017 (Close)

    MARKET STATS