Derivatives explained

hi my name is patty Hersh I'm a senior does your marketplace today I want to talk about derivatives and it was been reading Business News or listening to it on the radio who have been hearing about this enormous market and derivatives threatens to drag the whole financial system down so of course the question arises well what exactly is this derivative that everyone's talking about well there's good news and bad news the good news is that a derivative is is at its essence a very simple concept but the bad news is that it in sort of encompasses this enormous world of financial instruments so each derivative is kind of slightly different although it does have a single kind of binding element that makes it similar so what exactly is a derivative let's see if we can there spell I'd as simply as possible okay so here's a very simple example and it's based around our good friend Terry remember him here he is now Terry is Terry MacLeod his name is he's actually the head of the clan MacLeod okay and every year at around Thanksgiving the clan descends on Terry's home we're talking about hundreds of people and he has to buy turkeys to feed them all usually costs him about 20 turkeys okay we're talking big old turkeys there 20 Turkish it takes now in the past Terry used to go to the supermarket that week before Thanksgiving and he'd say excuse me 20 turkeys and the the butcher would say no problems here's 20 turkeys no problems but a couple of years ago he went to the store and they were out of Turkey store nothing it was a big problem for him because his family kind of revolted he had to serve them ham which was a complete nightmare anyway so he decided after that very traumatic event that he was going to try and prearranged the delivery of his turkeys so he went out and he tried to find the biggest turkey farm that he could this is bailey's farms and it's a way out in the countryside there and his old mr. Bailey is a very nice chat very accommodating and he said to mr. Bailey oh it's really way that you can kind of ensure that I get delivered 20 turkeys at Thanksgiving mr. Wace oh well I'll just guarantee that you know but I'll tell you what I can do I can allow you to kind of pre buy the turkeys you know if you pay me a certain amount of money now then I'll deliver you 20 turkeys you know any time you like before Thanksgiving the week before Thanksgiving it's always like that sounds like a good idea so he says not sure how much turkeys come in some years they're cheap thirteen dollars and years are expensive like 25 bucks how about we split the difference and say $15 $20 20 turkeys at $15 all right is mr. Bailey a science fair enough so Terry provides him with $300 that's 20 turkeys at a princely price of $15 and that money across mr. Bailey provides a note so like an IOU so I owe you 20 turkeys to pick up at any time before Thanksgiving and what we've got is a contract and this contract okay this agreement is derived from something underlying okay and what's underlying it are the turkeys gets this element underlying it but essentially what this is is a contract to deliver 20 turkeys before Thanksgiving paid for already by our friend Terry okay and this is the first okay of what one of three types of derivatives but it's it basically shows you what a derivative is a derivative is essentially a contract it's based on something else in agreement based on something else in this case turkeys so this is the first type so three types really of derivative and this is the first which is the future or forward okay because in the future mr. Bailey will be delivering twenty turkeys to Terry hence it's a future or forward contract okay the second type we have is called an option and an option is the option gives the buyer the option to buy or sell something okay so say in this case turkeys a little Terry's a little worried about mr. Bailey he's worried that mr. Bailey's farm might fail okay so it says very small chance of course tiny chance but it's possible so thinks will do is I'll hedge this contract by taking out an option okay what it is is he finds another turkey farmer all the way out here in the countryside and this is the Jones farm okay mr. Jones he's a nice enough chat but you know not as reliable but what he does is he says to mr. Jones or to what I'll give you 50 dollars 50 bucks for the right to buy 20 turkeys at $15 okay at any time before say the 23rd of November okay so what he's doing is is buying the option to buy cost him $50 in return he gets this note it's an option okay for 20 turkeys $15 right so he has the right to exercise that option at any point before say the 23rd of November okay so what he's done in total to secure to make sure that he's going to get his 20 turkeys absolutely sure he's paid $300 to mr. Eyre took to mr. Bailey here but in case there's a problem he's got this hedge okay which is his option to buy $20 or 20 turkeys at $15 which he's Chuck he's paid $50 for okay but that option can expire or will expire on the 23rd if he doesn't exercise it if he doesn't buy those turkeys doesn't exercise it he's paid $50 which he never sees again and he is there but he's actually secured his right to to get 20 turkeys should mr. Bailey not deliver okay so that's an option often often used by as a hedge by people okay so that's the second type of third type is called a swap okay and that's when you have say an instrument that has a floating interest rate so months to month depending on where the underlying interest rate is say LIBOR or whatever you don't know what the interest rate is going to be on the loan that you have or the bond and what a lot of people like to do is they later to take that floating rate where there's uncertainty and swap it for a fixed rate so say a bank will say okay well then you just pay you know 5% a month and we'll take the risk that one month it might be three and a half percent or one might one month it might be seven and half percent and we'll pay the difference so you know obviously they're gambling that so we're going to be lower or at about the same rate so that's how there's where the swap comes in where you swap a floating rate for a fixed rate okay but again it's a contract that's based on the underlying instrument which is in fact the bond or the loan that you're talking about so hence once again we're talking about this underlying and there are various things that can underlie these various contracts okay whoops underlying okay oops Angie I can't even spell so what have we got underlying well in this case we've got turkeys and turkeys are a commodity okay in commodities can include gold silver soybeans wheat whatever in the swap case wheat the underlying was an interest rate and interest rates in fact one of the the biggest underlying sand in the business in the business of derivatives so interest rates what else have you got well you got two we have M we have credit derivatives default swaps so credit isn't underlying what else we got there we had can have foreign exchange for X we can have M we can have the weather okay what are the weathers in there equities mortgages and on and on and on and on there's all sorts of things that you can have as your underlying instrument in your derivative but essentially once again was all the derivative is is this contract that's written based on the underlying and here's the great thing about derivatives because of this contract you can trade them okay employment derivatives are traded in two places they're either traded on an exchange okay so traded on an exchange kind of like you know the exchanges in Japan or the exchanges or the sp500 any of these exchanges or they can be traded over-the-counter and the over-the-counter caters whenever it's an agreement between one person and another so in an exchange you have this exchange that's working where you use the exchange trade through and you can see the prices listed in an over-the-counter market it's just an agreement in this case it's an agreement between Terry and mr. Bailey in this case of agreement between Terry and mr. Jones now how does this trade well say for example Terry's grandmother gets sick in Canada he decides to go to Canada and he has to yester bail on the whole Thanksgiving thing he can't have the clan MacLeod at his house what does he do well he cancels it obviously everyone who gets irritated him but he's the worst thing is he's got his paid $300 for these turkeys but he can trade this note he can go to his neighbor and say look the week before Thanksgiving I said look you know I need to sell this I thought these turkeys coming but I can't use them can you use them and the neighbor might say okay well you know I can use them I'll pay you $150 for it okay so clearly he's losing money on the deal but on the other hand he might go to that his neighbor and say if there's like a a problem with turkey supply that year as there was the year that he went to the supermarket he can go to his neighbor and he can say you know there's not very many turkeys this year how about I sell you these 20 turkeys give this note for these 20 turkeys and you can you can pay me $400 for it and the guy might say oh absolutely because then he can go to the supermarket and sell them for even more okay because there's so much demand so in that case Terry can see he can actually trade his note here's his contract or more than its face value at $300 and that's what happens with these contracts is that is that most of the people who are trading them aren't really interested in what's underlying at all they aren't interested in the interest rate they aren't interested in the commodities they were interested in the contract and the fact that they can trade that contract up or trade that contract down so what's the problem with this why are people worried about it there are basically two reasons firstly because people use a leverage when they took when they're using their derivatives okay which means you're using borrowed money which means that you know if you if the price of the the contract goes up then you know you make money there's no problems but if the price of the contract goes down it means you can lose all of your money because you borrowed a whole bunch means you can lose all of your principal very very quickly the second is because of the counterparty risk we talked about mr. Bailey's problems here clearly Terry is not a risk to mr. Bailey because mr. Bailey's already got his $300 so that counterparty is taken care of but mr. Bailey is a risk to Terry which is way to get this option because if mr. Bailey goes if mr. Bailey has a problem or as far as his farm goes under it means that Terry's got this note for 20 turkeys he's got a feed 200 people okay he's got no turkeys coming in because mr. Bailey is not going to be surprised supplying him perhaps he hasn't covered himself with an option in that situation that counterparty risk is caught Terry and that means it's going to leave him very badly needing a Thanksgiving drink

Channel: Marketplace APM

Views: 404,715

Rating: 4.9217272 out of 5

Keywords: Marketplace, whiteboard, derivatives, economics, business, financial crisis, Paddy Hirsch, economy, npr, radio, explainer, Borrow, Spend, Cost, Supply, Demand, Big banks, Put up dough, Stake, Trust fund, Exchange, Barter, Vend, Offer, Auction, Traffic, Unload, Deal, Dump, Hustle, Recession, Austerity, Financial crisis, Thrift, Layoff, Field, Trade, Work, Career, Livelihood, Occupation, Vocation, Commerce, Financial affairs, Money, Accounts, Analysis, News, regulation

Id: m3im-iJdhv4

Length: 10min 13sec (613 seconds)

Published: Thu Oct 15 2009

Reddit Comments

[u/PhysicsIsMyMistress]

I thought this video was going to be about differential calculus.

[u/wazzym]

I Always upvote educational videos!

[u/Geognosy]

This is a great explanation of derivatives.

[u/_aidan]

I am now one step closer to understanding economics. Now just 9,000 more steps to go...

[u/[deleted]]

I still don't quite understand what a derivative is.

[u/JagerManJensen]

Hmm so If I understood him correctly, basically the Lehman shock came from the fact that the housing prices dropped so much that they began to lose alot of money on those derivatives because they were betting that the prices would keep going up and they could make money on them, and then like a domino, because they had been trading them around to other people, those trades were also useless/toxic, so in one fell swoop the bottom fell out of the market because no one had the money to pay for the huge drop in prices. That is why the government came in and said, ok well pay for all these toxic "ious" so we can keep it business as usual.

I assume this must be a pretty common phenomenon within the derivatives market but maybe it was the size of the bubble that really took people by surprise. Hopefully its better regulated nowadays so the bubble cant get as big.....

[u/Joeybotv2]

Perfect timing for this to pop up on Reddit. After the $2 billion JPMorgan loss I was really curious how so much could be lost so quickly.