As the world melted down during the 2007-2009 collapse, investors were asking all kinds of questions about derivatives such as, "What is a derivative?" and "How do derivatives work?". At the time, I sat down to pen an article walking you through the basics but now, many years later, I want to return, expand, update, and clarify some of the original points I made so you have a better understanding of the role of derivatives in the overall economy, financial markets, and, perhaps, even in your personal investment portfolio.
Let's start at the beginning by answering the most fundamental question: What is a derivatives
What Is a Derivative?
The term derivative is often defined as something -- a security, a contract that derives its value from its relationship with another asset or stream of cash flows. There are many types of derivatives and they can be good or bad, used for productive things or as speculative tools. Derivatives can help stabilize the economy or bring the economic system to its knees in a catastrophic implosion due to an inability to identify the real risks, properly protect against them, and anticipate so-called "daisy-chain" events where interconnected corporations, institutions, and organizations find themselves instantaneously bankrupted as a result of a poorly written or structured derivative position with another firm that failed; a domino effect.
A major reason this danger is built into derivatives is because of something called counter-party risk.Most derivatives are based upon the person or institution on the other side of the trade being able to live up to the deal that was struck. If society allows people to use borrowed money to enter into all sorts of complex derivative arrangements, we could find ourselves in a scenario where everybody carries these derivative positions on their books at large values only to find that, when it's all unraveled, there's very little money there because a single failure or two along the way wipes everybody out with it.
The problem becomes exacerbated because many privately written derivative contracts have built-in collateral calls that require a counter party to put up more cash or collateral at the very time they are likely to need all the money they can get, accelerating the risk of bankruptcy. It is for this reason that billionaire Charlie Munger, long a critic of derivatives, calls most derivative contracts "good until reached for" as the moment you actually need to grab the money, it could very well evaporate on you no matter what you're carrying it at on your balance sheet. Munger and his business partner Warren Buffett famously get around this by only allowing their holding company, Berkshire Hathaway, to write derivative contracts in which they hold the money and under no condition can they be forced to post more collateral along the way.