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.
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.
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.. :/
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.
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.
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.
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).
I think you have the wrong idea about what a derivative is. The article does a pretty good job at explaining what a financial derivative is and gives some example of common ones. Financial derivatives have no real relationship with mathematical derivatives.
Financial derivatives have no real relationship with mathematical derivatives.
Indirectly they do. Option prices are derived from the underlying price as well as the implied volatility, time, and interest rates.
So when certain parameters change, the price changes. And that is a relationship with a mathematical derivative. The change in option price vs the change in the underlying (delta) is the first derivative, and then you've got gamma as the 2nd derivative. And so on.
A 'bet' produces no value. It is a fixed pot of money that a middleman may take a cut from before distributing the remainder to the people who have paid into the pot. The pot is static. The participants never get more out than they collectively put in.
Shares and derivatives on the other hand are linked to the price of an asset which may increase in value. When people buy and sell them they change the price of some aspect of the asset and therefore re-allocate capital to the most efficient and profitable investment. Done correctly the participants are making money, not 'betting'. The size of the 'pot' can go up.
A bet absolutely can produce value, it just can't produce money.
Consider a bet on a dice roll which is done solely for the purpose of entertainment (unlike bets on events which reveal information). The gambler gains utility from playing the game which presumably exceeds the utility lost due to the house take (otherwise, why bother playing).
Consider a simpler game: Street Fighter III. The house take is two quarters and you've got no chance of winning any money. Nevertheless, value is created since the players have a good time playing.
Yes, I agree that the company running the gambling is selling entertainment.
But the word 'bet' is wrong when applied indiscriminately to shares and derivatives. The way nazgulnarsil is using the word 'bet' marks a profound confusion about betting and stock markets. The whole point of stock markets is that the 'pot' can increase. With gambling the 'pot' decreases - in line with the entertainment value gained by the participants.
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.