Derivative

Once upon a time, Warren Buffet wrote in his Company’s Shareholders’ letter that, “Derivative Products are the weapons of the Mass Financial Destruction.”

We also hear the word “Derivative” on CNBC and other Economy news channels daily. So What is Derivative and How it works? And why the US Economy is down because these derivative products? This article is all about “Derivatives” in Layman’s Language.

What is “Derivative”?

Well, in Layman’s Language, A Derivative means a substance that can be derived from another substance.

Say For Example, Orange juice. Orange Juice is a Derivative of an Orange. The Value of Derivatives is derived from another Asset say for Example, Stock is a derivative of a company.

Mutual fund is a derivative of a derivative -

Now, stock is a derivative of a Company and Mutual Funds invest in stocks so when you buy shares (Units) of Mutual Funds, it means that you are buying a Derivative (MF Shares) of Derivatives (Stocks of a Company).

when you begin investing in derivatives of derivatives of derivatives – the more volatile the investment becomes.

Simple Example -

Suppose, your friend needs Rs.100 and you lend him Rs.100 at the rate of 10% per year interest. So you give him Rs.100 and he gives you promise on paper in written that he will pay you Rs.110 (Rs.100 + 10% interest) after 1 year. This on paper promise or an agreement is known as a Derivative.

Now let us discuss another scenario. Your friend needs Rs.100 but you don’t have 100 rupees with you. So you go with your parents and borrow Rs.100 for them at the rate of 4% per year interest rate and you give this borrowed Rs.100 to your friend at the rate of 10% per year. So at the end of the year you will earn 6%. You will collect 110 rupees from your friend and give your parents Rs.104 and keep Rs.6 with you. This is the Example of Derivatives of Derivatives. Banks do the same thing but on very very LARGE SCALE.

When you deposit your money with Banks, The Bank lend this money on mass scale and make more money from your money.

The Banks create Derivatives of 3rd Power at Mass Scale – Concept of Fractional Reserve -

Banks use more complex mechanism to make money from your money. In fact, Banks create money out of your money. Banks uses the concept of “Fractional Reserve”. It means that for every Rs.100 deposit, The Bank can lend Rs.1000 provided that the fractional reserve is 1:10.

Now this Rs.1000 is newly created in the economy because not the bank nor the government has this money to lend you. So Bank Lend Rs.1000 for every Rs.100 deposit. Say for Example the rate of interest is10% per annum than Bank will make Rs.100 on Rs.1000. In short the Bank will make Rs.100 from your Rs.100 deposit in the Bank and will give you just 4% of it (Savings Account interest rate). And not only this but this newly created Rs.1000 also bank keeps with it. So it means that Bank creates Rs.1100 (Rs.1000 as a Fractional Reserve + Rs.100 as an Interest) from your every Rs.100 of deposit and you get only Rs.4 interest rate.

Now the Banks such as Lehman Brothers and other Investment banks goes bankrupt because for them the Fractional Reserve ratio was 1:40 since decades. It means that for every $ 100 deposit, it used to create $ 4400 ($ 4000 as a Fractional Reserve + $ 400 as an Interest on $ 4000.)

Dollar was a derivative of gold. but today it is derivative of debt -

US Dollar was a derivative of Gold before 1971. Because it was backed by some amount of Gold but after 1971, it is a derivative of Debt means you can create more dollars by taking Debt only.

Mortgage is a derivative of house -

When you take a Housing Loan, The Bank creates Mortgage Agreement. It is the derivative of your House. Mortgage is the agreement between you and your Bank that you (The Borrower) will pay the Lender (Your Bank) the loan amount + Interest.

Rich people use Derivatives to become more Richer -

Derivative Products are like double edged sword. Means if you have proper knowledge of it, than it can make you more richer but if you can’t use it properly than it has potential to make you poorer or even Bankrupt.