Finance Bitch #1

The Obamanons are rolling out some convoluted derivatives regulation, and there is some discussion over how this might hurt airlines, farmers, and other "real" companies--as opposed to financial firms. Pathological hatred of bankers aside, I want to explain what I think is a very important detail in this discussion, especially as oil prices are rising and the bogeyman of "speculators" comes back. Incidentally, the price of oil dropped last week, so people stopped talking about speculators for a week.

Anyway, I'd just like to make sure all my readers understand the two main reasons that derivatives are used. Derivatives are, as their name suggest, financial instruments that derive their value from other assets. There are several kinds of derivatives, the main categories being futures, forwards, options, and swaps. Futures are standardized contracts that guarantee the delivery of a certain asset--say, oil--for a pre-specified price. Forwards are similar contracts, except that they are not standardized, but rather custom-made. Options give the holder the right, but not the obligation, to purchase or sell an asset for a pre-specified price. This is how stock options work, with the hope that the holder will work to improve the stock price and make it in his interest to exercise the options. Finally, swaps, the much-maligned instruments that AIG used, are actually very useful, and involve the "swapping" of cash flows on different securities.

Now, here are the two main ways derivatives can be used: to hedge or to speculate. Hedging consists of balancing out a long (profit when prices rise) position with a short (profit when prices fall) position. For instance, a farmer who sells corn might sell corn futures so that he can sell his corn at a known price instead of hoping that the price rises when he goes to market. When he grows his corn, he is long, and thus his future creates a balancing short position in corn.

Speculating, contrary to popular political wisom, is not a form of 21st Centural witchcraft. In fact, it is simply the opposite of hedging, whereby the investor takes either a long or short position in an asset, without balancing out the position. If you own stock and don't simultaneously short the stock, you are speculating in that stock. Similarly, if a bank wants to purchase an interest-rate swap to hedge against movements in interest rates, you can speculate in certain interest rate movements by taking the other side of that swap and not hedging yourself. To bring it closer to home, if you buy health insurance, you are shorting your health in order to balance out your automatic long position in your health. The insurance company, on the other hand, is taking an unhedged long position in your health.

Ok. Now you know.