Derivatives: From Options to Credit Default Swaps
by How hedging portfolio risk became gambling with the global economy.
One of the pervasive alleged causes for the financial meltdown in the U.S. is the credit default swap. Having been in the investment business, I know quite a few brilliant economists and investment managers. That said, I know about as many people who can describe a credit default swap as I do who can explain the physical properties of a black hole.
In the Beginning . . .
Once, long ago, portfolio managers, in their never-ending search to lessen the risk while increasing the reward in their portfolios, developed a sort of insurance called “options.” With an option, the buyer purchases a right and the seller collects a fee in return for an obligation to either buy or sell stock at a certain price.
For example, if a woman were to inherit a huge number of shares of Burlington Northern Santa Fe Railroad from her father who had worked there all his life, she’d have three choices as to what to do with this stock:
1. Sell it.
She is likely to incur huge capital gain tax liability in doing so.
2. Hold it.
She will lack diversification in her portfolio by holding such a large position in this one company which will have an unduly negative effect if it falls precipitously in price.
3. Buy an option
She can collect her dividend from the company and delay paying capital gain taxes unless and until the stock falls below a certain price, at which time she is guaranteed a buyer at that price.
It’s like insurance premium and she will pay a price for this right.
Very sensible. The person who sells that option to her is one who thinks the stock is a bargain at the agreed upon price and is willing to buy it from her at that price – and collect fees from her for that obligation until it falls.
Swimming Naked
One of my favorite Warren Buffett quotes is “You know who is swimming naked only when the tide goes out.” That’s even truer when it comes to options.
In our example, a woman buys an option to sell (called a “put”) when the stock falls to a certain price. Since she owns the stock, she has the right to sell it for that agreed price.
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