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What Are Derivatives?

For most of the history of finance, traders have bought or sold tangible things. A buyer could take possession of real estate, buy and run a business, purchase animals or machinery, or even physically hold stock certificates or gold bars. This created a clear relationship between objects and their value: it is easy to conceptualize how supply and demand affects prices when the items in question are physically real.

Things get more complicated when risk and insurance are introduced. Someone who owns a house may want to buy insurance in case the home is damaged or destroyed. Risk is not physical, it is abstract: the price of risk can increase or decrease based only on perceptions about the future, not the supply and demand for physical items. This does not make risk less important or real, but it does create a market for things whose value is “derived” from real things.

Derivatives in Real Estate

Derivatives have received criticism in the wake of the financial crisis of 2008-2009. Mortgage companies took individual mortgages and packaged them together into groups, so it became possible for banks to buy thousands of mortgages at a time – independent of the finances or credit of the people living in each individual house. Some bankers, however, believed that home prices could decrease. To protect their assets in case prices declined, they created a “derivative” product where people could make a profit if mortgage values declined. If prices went down, investors who held insurance would lose money on their mortgage investment but they would gain money from the derivative they owned.

Risk Management

Owning derivatives is essential to managing risk in modern portfolios. While buying derivatives as insurance costs money, the cost of the insurance is less than the profits made when prices increase. If prices decrease, investors are protected from losing all their money. It seems to run against common sense that investors can make money when prices fall, but the principle behind it is the same as insurance: companies need financial protection in case they incur a loss.