Derivatives Without Tears

A poor philosopher, Thales was challenged with the question: if you are so smart, why arent you rich? To prove that he too could be rich, Thales used his knowledge of stars, the heavens, and the seasons to forecast that weather conditions would be right for a very successful olive crop in that year. He then took what little money he had and went one by one to the owners of the olive presses used to convert the olives into oil. He made a small deposit to reserve each press for his exclusive use during the harvest time. Having cornered the olive press market in this fashion, Thales made the proverbial killing when the harvest produced a bumper olive crop and oil presses were in such high demand that Thales could charge almost whatever he pleased. Now he was rich, and had met the challenge.

 

Though Aristotle never used the word derivative, the contract in the story was no different from many modern derivatives: it had the necessary features of options and futures. Thales used leverage to obtain the right to use the olive presses, but not the obligation. Had the contract been slightly different, and required Thales to pay for the olive presses come harvest time regardless of whether he wanted to use them or not, the contract would have been a future or a forward. And in that case, the owners of the olive presses who entered into the contract would have been hedgers.

A complex subject like derivatives could hardly have been explained in a simpler manner. In fact, the above example has been extended throughout the book to illustrate various facets of derivatives: options and futures; futures versus forwards; swaps and structured notes; swaptions, caps and floors; collaterized mortgage obligations; and leverage.

While the first part of the book addresses to basic concepts, the second part explains how derivatives actually work. Use of derivatives, leveraging, hedging with futures and puts, synthetic futures (buying a put, , selling a call), hedging business risks, using derivatives to invest in interest rates are some of the topics dealt with in this part. The third section deals with understanding and managing risk while dealing in derivatives. The most interesting chapter in this part is one that deals with recent derivative disasters: Orange County, Barings, Metallgesellschaff, Bankers Trust. The authors describe in interesting details what went wrong in each of these cases. The last part deals with fiduciary responsibilities of using derivatives.

All those - experts and freshers alike - who want to understand an important aspect of the current financial scenario should find this book a boon. In a short span of about 200 pages, it covers a large ground, explains the finesse of this instrument, gives examples from recent history of derivative operations (the importance of leverage is explains with the help of Hillary Clintons example: how she made a fortune on cattle futures with the power of leverage) and takes a look at the future - all in a simple, easy to understand manner. Simply a must for those into finance and financials.

Abhijit Doshi