

What are financial derivatives? - btilly
http://bentilly.blogspot.com/2009/10/what-are-financial-derivatives.html

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ivenkys
What are financial derivatives is fairly well understood at least at a
conceptual level.

The interesting details are of course: 1\. What is the actual price of a
derivative product especially of a Credit Derivative product ? 2\. What is
your risk profile if you are holding a derivative product ? and the corollary
how do you become risk-neutral?

Its interesting to read the literature on this subject and find that the
experts don't even agree on the terminology to define something., forget the
actual definition.

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Nekojoe
The Wikipedia article is also a good port of call -
<http://en.wikipedia.org/wiki/Derivative_%28finance%29>

Derivatives are very useful instruments for some. The example of a wheat
farmer and a miller is useful for gaining understanding about what a
derivative is and how they can be used.

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vlod
Pricing derivatives and calculating risk realtime (i.e exposure) are really
where the banks make their money.

The big banks (Wall St) I've worked for had better systems that their
competitors and therefore have a slight advantage of when to get in and _out_
of positions.

Of course, they still got screwed up with subprime.. :/

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nazgulnarsil
my take: the term derivative is apt. price hinges on expected changes in
future market conditions, thus if we graph the price of some asset as a curve,
you can say that the derivative (instantaneous rate) at any point represents
market expectations at that point. people make bets about whether the slope of
the derivative will increase or decrease. these bets are financial
derivatives. they are distinct from regular purchase of stock because how much
money you make is not directly tied to the price changes of the stock, you can
make any arbitrarily sized bet with whomever will take you up on it. want to
make a billion dollar bet on a penny stock? you can, and you don't have to
worry about unwinding a position. this is why the financial derivatives market
can dwarf the real assets market in size.

all the rest (puts, calls etc.) are just the structure of the betting.

If my simple explanation is missing something vital please do tell. this is
off the top of my head at 5AM and I'm not sure it holds.

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BobbyH
Your take sounds plausible, but there are several conceptual inaccuracies:

1\. Financial derivatives have no relationship to derivatives in calculus.
(The two concepts are just coincidental namesakes.) A financial derivative is
called a "derivative" because the price of a financial derivatives is
_derived_ from the price of an underlying something. However, the price of the
underlying asset is just one of many inputs into the price of a derivative on
that option, so nobody is taking a "first derivative with respect to price".

2\. It would be impossible to make a billion dollar bet on a penny stock using
"plain vanilla" (regular) derivatives like options, because stock options are
not offered on thinly traded penny stocks (because nobody cares about the
stock, so nobody will care about the stock option, so an exchange won't invest
in offering that stock option). The only way you could make a billion dollar
bet on a penny stock is if you found an large institution or billionaire to
make a customized bet with you about that stock (or a coin toss). However,
there is almost no liquidity for a non-exchange-traded option of this kind.

3\. A stock option and its underlying stock have an intimate relationship. An
options trader will often buy or short a stock to hedge the risk s/he has from
owning the stock option (and vice versa). An options/derivative trader
definitely has to worry about how "unwinding a position" in one market will
affect the other market.

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cperciva
_Financial derivatives have no relationship to derivatives in calculus_

That's not quite true. As a stock option comes close to expiring, its value
approaches the difference between the market price of the underlying
instrument and the option strike price... as long as that difference is
positive, of course. The complexity of financial derivatives comes from their
nonlinearity; but if you buy a call option and sell a put option for the same
strike price, you'll be precisely betting on the change in price.

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BobbyH
Yes, you can use calculus/derivatives to value many financial derivatives.
However, you can also use calculus to model how much water is in a bathtub
that drains a different amount of water depending on how much water is in the
bathtub. My point was that financial derivatives weren't named after math
derivatives.

Also, to elaborate, if you buy a call and sell a put, you will be betting
precisely on the change in the price [of the underlying] because you have
created a synthetic stock position (because of Put-Call parity:
<http://en.wikipedia.org/wiki/Put%E2%80%93call_parity>).

