What are derivatives? Could they cause the financial system to crash?

Answer 1

Derivatives are contracts against the value of some other thing such as the value of IBM stock, the price of corn, interest rates, or the relative price of two different things such as fixed versus floating rates or two currencies. They come in two main varieties.

The first is the futures/forward contract. A forward contract would be, for example, when Kraft agrees to purchase milk for cheese from ADM at a future date at a price fixed today. A futures contract would be an agreement between a party, such as you, and another party that is unknown to you, to deliver or receive delivery of say 30,000 barrels of home heating oil, with a cash down payment that is remarked to price changes every day, at a specific date, at a specific place and in a specific quantity, at a set price.

The other variety are options and warrants. There are a few other items mixed in here such as convertable preferred stock, but we will ignore them since they are just complex forms of the basic idea. Warrants are a long term right, but not obligation, to buy shares of stock from a company at a fixed price either on a fixed date or at any time prior to a fixed date. Options come in two forms, either the right to buy or the right to make someone else buy, or the right to sell, or the right to make someone else sell some asset at a fixed price either at a fixed date, or at any time prior to the fixed date.

So, for example, a call option on IBM stock gives the buyer the right to buy 100 shares of IBM at an agreed upon price anytime prior to a certain date from another party. A put option on IBM gives the buyer the right to make the counter party buy 100 shares of IBM at a fixed price anytime prior to a fixed date.

When used as insurance, they reduce the risk in the market. Farmers, for example, can sell their corn when they plant it, if they are afraid the price will fall to lock in a price. Shareholders can buy puts to guarantee that if the price falls too far, they can escape.

On the other hand, you could sell corn at a fixed price in the futures market and not be a farmer on the expectation the price will fall in the future. You will receive the down payment and interest on the money, say $50,000, but you will be obligated to provide $250,000 in corn, say in August of next year at todays prices. Further, if prices increase, you will have to give back some of the $50,000. If the price were $1 per ear of corn (I have no clue what corn sells for) then you would be obligated to deliver 250,000 ears of corn. Now imagine a drought hits and prices skyrocket to $2 per ear. You would need $500,000 to meet your $250,000 obligation because of course you are obligated to deliver corn, not dollars. Contrarywise, if the price of corn fell to $.50 per ear, you would pocket $125,000 at delivery from the fall in prices.

Yes, derivatives can cause the financial system to collapse if too many large gambles were made, sufficient to stress the system overall. It has almost happened on several occasions.

Answer 2

The close to crumple grew to become into the effects of banks, very own loan companies and different creditors compelled and compelled to furnish out mortgages to those that could desire to no longer arise with the money for them, and could desire to never wish to pay off them because of the fact they did no longer have the money for the money. tens of millions of greenbacks worth of ineffective domicile notes. they could desire to never have been allowed to purchase properties first of all, if that they had no ability of paying the month-to-month paments. there's no inalienable top to possess your guy or woman domicile. How 'honest' grew to become into that to the rest persons?

Answer 3

Please do your own homework.