Financial Literacy for Dummies aka Me (Week 7)

Introduction

Talking about money has always been kind of dirty in my mind. The idea of wanting more seems “greedy” and so when my family lost a bunch of money after working with a financial advisor a few years ago, my parents took it as a sign to just hunker down and save instead of investing. As I got older, I realised I was extremely avoidant when it comes to money. This avoidance also led to a lack of basic understanding of the mechanisms of investing. Hence, I am kickstarting this Financial Literacy for Dummies series as an accountability goal this second half of 2023. With education, I hope to become more educated and more realistic about investing (as opposed to extreme risk aversion).

How I plan to go about this is to read Investing 101: From Stocks and Bonds to ETFs and IPOs, an Essential Primer on Building a Profitable Portfolio and provide my learnings as well as additional notes on topics mentioned.

Derivatives

A derivative is, as the name suggests, a financial product that derives its value from something else. Well, to be honest, this definition does not necessarily speak to me. I mean what isn’t derived from the value of something else? Are stocks not also something derived from something else?

So I had to turn to our dear friend ChatGPT:

A derivative is a financial instrument or contract whose value is derived from the performance of an underlying asset, reference rate, or other variables. In simpler terms, it’s a financial product that “derives” its value from something else. The underlying asset can be anything such as stocks, bonds, commodities, currencies, interest rates, or market indices.

The reason why stocks are not considered derivatives is because they represent direct ownership in a company. When you buy a stock, you are buying a share of ownership in that company. The value of the stock is directly tied to the company’s performance and profitability.

On the other hand, derivatives are contracts between two or more parties, and their value is based on the expected future price movements of the underlying asset. Derivatives allow investors to speculate or hedge against price movements without owning the underlying asset itself. Common examples of derivatives include futures, options, swaps, and forwards.

In summary, while both stocks and derivatives derive value from something else, the key difference lies in the direct ownership aspect of stocks versus the contractual nature of derivatives. Stocks are considered traditional securities representing ownership, while derivatives are financial contracts whose value depends on the performance of an underlying asset or variable.

So from what I am hearing, there is some reference when it comes to derivatives. That the product itself is being used to derive some value but is not actually the main nature of the product; it is the reference/speculation that is important.

When discussing derivatives, we have to talk about the types, of which we have swaps, options, futures and forwards.

Swaps

Swaps is the one I have the most difficulty grasping. It is a contract based on swapping two assets that provide cash flows (e.g. loans). It is usually when the assets are determined by a variable like interest rate. Hence, it is a form of derisking the variable element.

A vanilla interest rate swap agreement usually consists of 2 parties agreeing on swapping interest rates where one party is promising the return of a fixed interest rate while the other is based on a variable one usually tagged to an index.

Options

I like to think that options are similar to that feature you get when travel websites allow you to lock in a price for a small fee. The thought process is that you are able to lock in a “good price” at the present moment, and at some determined point in time, have the choice to exercise the purchase of the asset at said locked-in price regardless of how much the market has changed since then.

Should I buy now or should I buy later? A tale as old as time. And options (together with forwards and futures) are the concoction humans have created to derisk that.

If you bought the option to purchase a stock (aka stock option) for a strike price of $50 for a month in the future. When you discover a month later that the stock price has risen to $60, you can happily exercise that option and purchase the share at a $10 profit (of which the value is stored in the stock).

Futures

Futures are an option-adjacent contract except that the contract necessitates the individual in the contract to go through with the agreed price regardless of the market price. This tends to be, according to the book, a high-risk high-reward type of game. Usually based on a commodity like corn or oil, we can see how it might be this way considering how much commodities do fluctuate.

Long and Short

Long and short are central concepts to investing. We are often expecting an outcome in investing that will result in some financial gain. That may often come in the form of expecting the price of a security — long investing. However, equally valid is someone banking on the fact that the price of something decreases (or maybe increases not as much) ie shorting.

A derivative is a contract that derives its value and risk from a particular security (like a stock or commodity)

This gives rise to the concept of short selling, which is selling a stock you do not already have, hoping that the price of that stock drops so that you can ultimately get a profit from the difference between the amount you sold it at and have to buy it back at.

A classic example is the shorting of Gamestop in the story of Goliath and David. TLDR: Wall Street people starting shorting Gamestop in anticipation that its share price will tank were unexpectedly faced with a group of radical Reddit people (?) who tried to push the prices of the stock sky high, hence making these short sellers to eventually make a tremendous loss when they did have to buy back to stocks they owed from short selling.

Now that we have a good idea of the financial tools available, I’ll start looking inwards and examining my own financial profile and portfolio in Chapter 9: Your Investment Portfolio.