Financial IQ: Derivatives

Everyone in the world wants to be safe. There’s no world war but people are scared for their loved ones who go to work everyday to bring food to the plate. The enemy is not another country, it is a broken financial system which has recessions and booms in its very roots. Due to lack of Financial Education in our schools, we are unable to understand what to do with our money. The books on management and economics are useless because they are filled with too much technical jargon for everyone to understand. So, lets go over these technical terms one by one.

I will discuss Derivatives from a non-commerce student’s perspective and we will soon go to CDOs, Credit Default Swaps, sub-prime loans and money.

Derivatives

Suppose you need to buy orange juice for a party you are throwing at your house. You send your housekeeper to the market and he sees that there are 5 shops lined one after another. You have asked him to buy fresh orange juice so the packaged versions are out of the question.
orange juice derivatives example

Because he has no idea about the quality of the orange juice offered by the 5 shops, he comes up with an idea. He buys two glasses of orange juice from each shop and puts it all in a huge container. By doing so, the risk that the orange juice will be sour is minimized because if the juice from one of the shops is sour, then the sweet juice from the other shops will compensate for the taste and your reputation will not be destroyed. This is the whole concept of derivatives. You minimize the risk by buying from different places because a loss in one will be compensated by a profit in the other and it will make you more stable financially.

But here’s the catch:

  • It is ensured that you will not get the best orange juice.
  • If someone gets sick, then you have no idea whose orange juice it was that caused the sickness.
  • Your knowledge of the market doesn’t increase with repeated purchases because you can never know who sells the highest quality product.
  • If the orange juice from two or three of the shops is sour, then you will be left with a bland mix which will give you no satisfaction(profit).
  • You have to believe the word of your housekeeper if he says that the oranges this season are bad because he brings you a similar bland mix everytime, not tasty orange juice on one day and bad orange juice on the next.

Don’t trust your housekeeper and tell him to taste the orange juice from each shop and buy the best one.

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