In the beginning, after reading for some time, and only some months back by the way, I decided to post on this blog asking the question: “..what did ‘ETF' stand for?� From that moment on I was swept away with being educated and shown where to find most every answer to my investing questions from Bill and other great folks on this website. To make a long story short I now own FXI and continue shedding myself of the Mutual Fund stigma.

Help!

While reading Bill's "hotspot" article, the following quote caught my attention:

"the first quarter saw the introduction of the first ETF tracking a broad commodity index, Deutsche Bank Commodity Index Tracking Fund (DBC
Financials Sponsored by: DBC23.94, -0.17, -0.7%). The launch was notable because it marked the first time regulators had approved an ETF that used derivatives for the commodities exposure, potentially opening the door for more products of that ilk."

My questions: Can someone explain exactly what are derivatives and how do they work? What are the benefits vs risks of this investment istrument? Having researched the "derivative" definition on Investopedia.com, I would welcome a more novice-oriented explanation.

Warren Buffet has written some unflattering things about derivatives which led to my interest in learning about them.

Thanks!

oratier,

Please take the following comments regarding derivatives as "unqualified", I'm simply a private investor and have pondered the same questions you have.

I'll try to be as concise as possible (and if someone sees a mistake in what I write, please correct me).

Derivatives cover a whole range of instruments, from futures and options (which are "relatively" well-known and have a certain history), to some really exotic things like collaterised debt obligations (CDOs) and other credit-based derivatives.

Basically, derivatives allow you to have some of the value of some asset (shares, bonds, currencies, commodities, cash, loans, etc.), even if you don't actually own it. If this seems a little fishy to you, you can understand why Warren Buffet is wary of the things.

When it comes to things like CDOs, what's happening is that the issuer (say, JP Morgan bank) is passing on the investment risk of holding a bond onto an investor. This is what has been happening on a massive scale, since the CDO market is now worth between $12 trillion and $17 trillion (US GDP 2005: $12 trillion). A lot of investors are buying up these things, in some cases not knowing what they're really buying (in fact, even the experts acknowledge that they have no idea where some of the loan risk is going).

Still, these 'experts' are saying "trust us, we know what we're doing." On the other hand, you have a guy like Buffet who has tried (according to his 2005 annual report) to close the derivatives contracts of his insurance company General Re over a period of 15 years, at a cost so far of ca. $400 million.

You've got to decide who you want to trust.

By the way, personally I'd stay away from anything to do with Deutsche Bank. Yeah, they're huge and they're German, but don't trust them (I still bank in Germany, but with a much smaller bank, so don't take this as some sort of racial comment). Earlier this year, they froze a property mutual fund (one of their biggest), not allowing any investors to pull out money. Their retail bank arm in Germany has some of the worst charges, and I had a real trial to close my accounts there. I know, you shouldn't let emotion get in the way of your investment decisions, but this bank is nasty.

Hope that helps.

just_observing,

Firstly, thanks for replying, however, the partial comment below from your reply has taken me aback:

"Basically, derivatives allow you to have some of the value of some asset (shares, bonds, currencies, commodities, cash, loans, etc.), even if you don't actually own it. If this seems a little fishy to you, you can understand why Warren Buffet is wary of the things."

Aren't ETFs (the subject of this thread), and mutual funds part ownership of assets? Or are you indicating that derivatives offer zero underlying assets, only the promise of payment by the derivative provider? If the latter is the case, then I am in complete agreement with Mr Buffet.

The rest of your reply is completely over this novice's head, however, I sincerely appreciate your taken the time to reply

oratier,

Sorry for the confusion. I'll try to explain in further detail, plus I'm learning as I read up on this stuff. (I have a feeling the pros on this site are having a little giggle at us two novices here, but that's ok, I'm sure it's a relatively friendly giggle)

As far as I can understand, a derivative removes you a step further from the actual asset (when compared to an ETF or mutual fund). It's a sort of "promise" on a promise.

So, "zero underlying assets" is not quite 100% accurate, but in the real world outside the golden towers of Wall Street and Co., I'd have to agree with you (and there's a lot of experts in those towers who'd be laughing at me right now). Does that help? Any comments from the pros here would help.

Regarding Warren Buffet and his experiences with derivatives, I'd suggest reading the introduction of his 2005 annual report (Page 10, halfway down):
(www.berkshirehathaway.com/2005arn/impnote05.html)

As for the Deutsche Bank and their property fund 'Grundbesitz Invest', here's the story:

http://tinyurl.com/azkb2

The words "I'm not impressed" come to mind.

If you have any other specific questions about my previous email, please don't hesitate to ask. I need to be a bit more concise. ;-)

Take care.

I returned to Investopedia.com and the following is their direct quote. Permit me to add MY LIMITED understanding (in parens and CAPS) of what they have written.

"Derivative

What does it Mean?
In finance, a security whose price is dependent upon or derived from one or more underlying assets.(COULD BE AN ETF OR MUTUAL FUND)
The derivative itself is merely a contract between two or more parties.(COULD BE AN OPTION)
Its value is determined by fluctuations in the underlying asset.(COULD BE A STOCK, OPTION, ETF OR MUTUAL)
The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes.(UNDERSTAND THE FIRST THREE CAN BE CONSIDERED HARD UNDERLYING ASSETS; HOWEVER, NOT SURE ABOUT THE REMAINING THREE)

Most derivatives are characterized by high leverage. (I'M LOST HERE)

Investopedia Says... Futures contracts, forward contracts, options and swaps are the most common types of derivatives.(WHAT HAPPEN TO STOCKS AND BONDS AND IS THE FOREX MARKET DERIVATIVE BASED?)
Because derivatives are just contracts, just about anything can be used as an underlying asset( IS THE OPTIONS MARKET DERIVATIVE BASED?. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region.(SO DERIVATIVES ARE NOTHING MORE THAN A BET ON SOME FUTURE EVENT?)

Derivatives are generally used to hedge risk, but can also be used for speculative purposes. (COULD BE OPTIONS)

For example, a European investor purchasing shares of an American company off of an American exchange (using American dollars to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into euros." (IS THE CURRENCY MARKET IS DERIVATIVE BASED?)

Thanks,

Oratier,

just like you I'm pretty much a newbie in the finance world but I will share with you what I know about leverage and swaps.

Leverage:
Leverage simply means that the money required to buy the derivative is lower than the total cost of the contract. For example, using a leverage of 100 to 1, you could buy a Forex contract worth 100 000$ for only a 1000$ cash down. This means for every fluctuation of 1% in the contract, it would be a 100% change for you. If the underlying asset in your contract increases to 105 000$, then you "won" 5000$ on your 1000$ initial amount. Obviously you can lose a lot if the underlying asset goes down in price. Another way for you to use leverage is to borrow money to invest. If you invest 10000$ and borrow another 10000$ from your bank then you have 20000$ worth of asset but only 10000$ of your own money invested. Then again, if your assets fall to 0$ you still owe 10000$ to your bank.

Swaps:
The best way I can explain swaps is by using Bill Gates as an example: Bill is the wealthiest man on earth but he's stuck with all these Microsoft shares. He cannot sell a lot of them because then he will significantly drive the prices down, lowering his own wealth. Instead he calls an investment banker and ask him to temporarily "SWAP" shares of microsoft with another stock to diversify his portfolio, this is called an equity swap. Obviously there is a cost associated to that and the investment banker will make sure to collect some premium to compensate the risk he his taking.

Does this shed any light?

cotemath

"Does this shed any light?"

Maybe, but let me proceed cautiously.
The mistake I'm making is considering derivatives as a noun, a thing, just like a stock, or a bond is "a thing". After reading the replies, I'm declaring derivatives a system... meaning any investment vehicle that involves "leverage" can be classified as derivative. A margin account is a derivative system, as are naked options, FOREX, Futures, currency trading, etc,. Am I getting warm?

Thanks

Leverage and derivatives are 2 different concepts, but derivatives "usually" have high leverage (like 100-1) because in normal market conditions the fluctuations are low (fractions of percentage daily). this leverage amplifies gains/losses to more interesting amounts.

Unlike bonds, cash, stocks which represent tanglible asset (owing some shares makes you part owner of a public company), derivative are created out of thin air. Their goal is to carry the risk underlying a correlated asset, therefore you could see them as an insurance policy between an investor (wants to minimize risk) and a speculator (risk taker). For example, you buy Microsoft shares but you want to make sure you don't lose all your money if the shares go down in price, so you buy a PUT option that guarantee you a minimum sell price for a given timeframe. You pay a premium (option price) to the PUT seller in order for him to assume the risk for you. If the price of Microsoft goes down, you can execute the option and sell at the PUT option price, the seller is then required to buy it from you. On the contrary, if the price goes up, you make the profit but you have lost your premium (option price) to the seller.

The option contract does no represent any tangible asset (like a share, or a bond) but it's value is related to (or derived from) a stock price, that's why it's a derivative.

oratier

I'd have to say you're as warm as any of us are ever going to get. (Unless someone else chips in with their view.)

In the end, the question I'd suggest asking yourself is: who are you going to trust? Warren B. or the spiky-haired suits in the towers on Wall Street & Co.? I think you know who I'd trust. ;-)

Here's a small list: Baring's Bank, Allied Irish Bank, LTCM, Refco. Derivatives can go horribly wrong, even for the "pros". In answer to your question about risk, well, the risks are huge (and in many cases, unknown).

I'd stay away, but maybe Bill can enlighten us.

Thank You!

Your explanation of options as derivatives was indeed the "smoking gun" in my understanding of the definition of derivatives. Let's stay with options for my next and hopefully last question on this thread. We are all aware that the concept of options came to prominence during the great dutch tulip debacle of the 16th(?) or 17th century; and I'm sure Warren Buffet is fully aware of their uses as per the following quote from his 2005 annual report.

"Berkshire utilizes derivatives in order to manage certain economic risks of its businesses as well as to assume specified
amounts of market and credit risk from others. The contracts summarized in the preceding table, with limited exceptions, are not
designated as hedges for financial reporting purposes. Changes in the fair values of derivative assets and derivative liabilities that do
not qualify as hedges are reported in the Consolidated Statements of Earnings as derivative gains/losses. In 2002, Berkshire began to
enter into foreign currency forward contracts with the objective of partially managing corporate-wide adverse risk from the decline in
the value of the U.S. Dollar. Berkshire has also written equity index options and credit default swap contracts during the last two
years."

My question is: Bypassing equity options and forex which Mr Buffet clearly utilizes by the above quote, is there a particular type of derivative he dislike.

And, if cutting and pasting attributable quotes is illegal, let me know.

Thanks.

I think Warren Buffet is getting concerned with the increasing number of investment that are made with high leverage, especially derivatives. If the tier who sold you the "derivative" to assume your risk with a high leverage and then resold that risk to another tier (an investment banker for example) and so forth, any default (or even bankruptcy) of one of these parties in this chain might create a domino effect that would destroy all wealth on his way, including yours, even though you thought you were protected against that. This is because there is no regulation on derivatives and investment bankers will always sell them regardless if they can really back them with cash. In normal market conditions + infinite money printing that might work, but a small glitch in the economy might trigger that domino effect, thanks to the high leverage of these derivatives. It seems that this is the danger that Warren Buffet is talking about.

So, in other words, relying on derivatives to protect your capital in economic turmoil is like relying on a soon-to-be-bankrupt insurer to protect your house, you might never get your money back.

Got it.
My thanks to all who contributed.