Monday, May 31, 2010

derivatives

Readers of this blog may be excused if they think my ignorance has recently grown so slight that I've had to resort to decoding British and Irish slang. Sadly, this is not the case. Today, I will branch out into the rarely visited world of finance--well, rarely visited by me--to explore the meaning of derivatives. No, not "derivative"--unfortunately, I'm all too familiar with this standard dismissal of much contemporary fiction. In literature, "derivative" is kind of a kiss of death adjective. In the world of finance, though, "derivatives",  are apparently sometimes attractive. Lately, however, derivatives have been much in the news, and causing a bit of trouble.

I was, well, not comforted exactly, but relieved to know that there are a lot of other Americans who are clueless about this financial term. Now that it's clear that certain decisions in Congress will bode either ill or well for the derivative market, I thought it might be time to enlighten at least myself on what these blasted things are.

In literature, 'derivative' means something like 'stale' or 'a pale copy of the original'. I think the word means something much more neutral in other circumstances, maybe 'coming from'. In fact, now I think about it, it's probably a sibling of 'arrive'. The suffix 'rive' probably does mean something like 'come' or some sort of action word like that. We'll see.

Anyway, derivatives must have their basis in some other source. They must be dependent on some other financial vehicle for their existence. How they are dependent, I have no clue. From recent financial talk, though, I get the feeling that their presence is like the bottom part of an iceberg lurking under the water. Or are they not something so stationary, but really something more like a shark, that has to keep circulating to keep breathing?

...Well, just by chance, one of the first explanations I came across was a podcast by Christopher Hayes of the Nation, and the bonus was that I learned of his podcast show called The Breakdown, which attempts to enlighten us in short, not too taxing segments on various matters crucial to our time. If you'd like to cut to the chase--and I'd highly recommend it, actually--please check out his podcast on derivatives here . He speaks with Bart Chilton of the Commodities Futures Trading Commission and together they very helpfully break it down for us.

But if you must know, here is what I gleaned from all of it. Basically, the word 'derivatives' and the word 'futures' are interchangeable, at least in their economic sense.  It's called a derivative because it derives its value from something else. Starting out as these ideas did in agriculture, that something else was a concrete thing. It's much less the case now. Anyway, it's all about trying to determine what will be the market value of something at some given point in the future. The analogy is again to agriculture, where a product is cheap at the time of harvest because its plentiful but more expensive later when it's not easily come by. It's all about what people think will happen in that future. You can call it guessing, you can call it speculating, you can call it gambling. But it is part of the way our financial markets run, and it's also one of the ways a market determines what's a fair value for something at any given time,  and I think the idea I come away with is that we could not very easily get by without them.

22 comments:

  1. Seana,

    I work for a finance company and hear "derivatives" bandied about every now and then,yet had no clue what it meant. Now, I do.

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  2. Sean, on a personal level I find that reassuring, but on a collective level somewhat alarming that even people who work near the center of financial industry may not know what these things are.

    Chilton was quite an interesting guest on Hayes's show, and to answer my own question it sounds like derivatives have come rather recently to be more like that submerged iceberg than the ever moving shark, because big institutions have gotten involved in derivatives and tend not to move quickly in and out of positions but to sit and stay. "The massive passive" was his term for it, which I like a lot--it's the kind of phrase that tends to stick with you.

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  3. I'm grateful for the explanation - especially the cartoon. Our welfare state came into being when we had industry producing things that could be sold etc. It has always baffled me how, now that Belfast has none of the big shipbuilding, aircraft, or linen manufacturing industries left that it had a generation ago - and with 80-90% of the employed working in service industries or the public sector - where the money is coming from to sustain it all. Maybe Sean knows, or are we heading for even greater economic disaster?

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  4. Seana,

    I'm in telecom,not a money / trader dude, so you can rest easy. Mathematics was not my strong suit, way to left brained.

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  5. Philip, that is a very good question. I don't think places like Detroit have found any real answers to this kind of problem either. And my town relies hugely on the presence of the university and tourism--there is still agriculture, but the current terrible unemployment rate is evidence that none of this is enough.

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  6. Sean, it's interesting though that even those not formerly inclined are starting to take an interest in learning a bit more about the financial realm, now that we see it all falling to pieces around us.

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  8. Advanced financial terms have always made me shift uncomfortably in my chair. Thanks to you, I can now shift less.
    ================
    Detectives Beyond Borders
    "Because Murder Is More Fun Away From Home"
    http://detectivesbeyondborders.blogspot.com/

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  9. But that doesn't make you shiftless, Peter.

    I'm afraid you actually have to thank Chris Hayes, Peter. I am simply a reporter.

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  10. But the medium is the message, so you get credit.

    The invocation of futures was helpful, since I think more people are familiar with that term than with derivatives.

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  11. Yes. Not that I learned what futures were so terribly long ago, but once I realized they were intertwined, I felt like I was on more familiar ground.

    Let's just call this a public service announcement.

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  12. It has served me well, It's not that I was shaky about the meaning of derivates before I read this post, it's that I had no idea what the hell they were.

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  13. Apparently, almost no one does. But as Chilton says, they are freakin' humongous.

    I think it's slightly weird that Americans, who are supposed to be all about money have very little idea of what goes on in the higher financial realms. You'd think we'd all be extremely keen and study financial affairs day and night. I absolve you, Peter, on account of your Canadian roots, but it still doesn't explain how so much of the big shifts of the markets have taken so many of us unawares.

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  14. I'm surprised you didn't mention that Derivatives are the basis of integral calculus. You never heard the term in that context?

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  15. Sadly, no. I didn't do calculus. But I appreciate the expansion of the definitions here.

    The parallel with the financial term is that a value derives from a more known value--is that more or less the idea?

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  17. I don't know if the financial term has been inspired by the mathematical usage. There are similarities but also differences.
    But yeah, a derivative is in both cases a derived value.

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  18. Hey Seana, just stopping by. If I didn't have a headache brewing I'd read some and check things out. I have to say, I love the title and it sounds like something I can probably relate to since half the time I feel like I'm clueless on stuff I probably should know.

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  19. Thanks for checking it out, Glenna. Generally, you'll learn more from the commenters than the original poster, but that's a good thing.

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  20. Marco, it's kind of strange how much calculus has been coming up in the last couple of days. Math is not generally one of those things that haunts me.

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  21. Ah Marco beat me to the comment re: derivative in the mathematical sense.

    Seana - It has been awhile, but every now and then I get a few spare moments and absolutely love reading this blog. It's strange, but when reading this I don't mind realizing how little I actually know.

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  22. And with readers like you, Brian, I don't mind admitting the same in the first place.

    It's nice to see you checking in here and there when you can. I know you're ultra busy, but I do miss your blog posts.

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