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All the investment options discussed in previous posts has either low returns or high risks. The chances of ordinary investors getting high returns without some risk containment from investment in shares are rather slim. Low return investments like bank deposits or bond purchases would give negative real returns while investments in stocks and other instruments may result in the erosion of capital unless of course the investor is extraordinarily lucky.
Luck is not some thing that can be defined or depended upon. Therefore investing one’s hard-earned money in high-risk instruments without risk reducing provisions is sheer foolishness.
It is at this point that I wish to introduce the instruments under the name Derivatives. They are not sophisticated instruments, as everybody knows. In subsequent articles I will introduce the various instruments under derivatives and explain how to effectively use them to reduce risk and finally come to a strategy that gives a return of more than 100% per year in the US markets
A derivative is something derived from something else. For example petrol is a derivative of crude oil. Derivatives are designed to reduce risks in all sorts of situations. For example there are weather derivatives that reduce risk from changes of temperature. Naturally the question arises. ‘How does a derivative reduce risk?’ Risk is some thing that can be measured. Therefore it can be quantified and transferred to others who wish to buy it for a reward. A typical example of transferring risk is insurance. Every one of us has taken insurance of one sort or another. When we buy insurance on our car we are transferring the risk and consequent losses from an accident to an insurance company. The insurance company receives a premium for taking our risk. Derivatives are doing exactly the same. They help you to transfer the risks to others who are ready to purchase them for a payment of some sort. Similarly when you buy a share, derivative instruments related to shares offer you a means to reduce your risks associated with the shares. When you have foreign exchange- related instruments, derivatives associated with them offer you a means to reduce the risks associated with them by transferring them to others who want to buy the risk for a return
It should be understood clearly that risk is not eliminated by derivatives. Derivative instruments transfer risk from investors to others who want to take them. The comparison of insurance premium paid to an insurance company and your car accident is very pertinent here. We reduce our risks from derivatives; some one else takes the risk from us for a price. In certain situations the risks associated with some instruments are unlimited and those who buy the risks may be making misjudgements on the quantum of risk they buy. The case of LTCM is a typical example. People who floated LTCM that included Myron Scholes and Robert Metron, the Nobel Laureates for Economics in 1997 for their contribution on Derivative instruments failed to assess the risk associated with their position. Similarly AIG misjudged the risks associated with the insurance they provided against sub-prime home loans and paid for that dearly. At the same time Goldman Sachs and Paul Johnson betted against these instruments and made profits by billions of dollars from their derivative positions.
Derivatives make a lot of headlines on the failure of big institutions that buy the risks without fully realizing the implications. Most of the time the most unimaginable and impossible happens and those who insured them go under. Titanic was said to be unsinkable, but it sank on its maiden voyage itself making headlines.
Even Buffet called derivatives as the financial weapons of mass destruction. However the potential of these instruments to reduce risks can never be undermined.
WILL BE CONTINUED…
CYRIAC J. KANDATHIL, Chief adviser, www.AssuredGain.com