FP Article 33 (For a FREE eReport on Dollar-Cost Averaging and Value-Cost Averaging, click here.)

Weapons of Financial Mass Destruction - Really?

by Rajen Devadason

In February 2003, Buffett completed his Chairman's Letter of 2002 for Berkshire Hathaway, his powerhouse of an investment vehicle, which trades as the most expensive stock in the world. In it he mused about the growing dangers associated with the escalation of derivative usage within the financial system. In addition to the grave warning he gave - see above - on behalf of his long-time partner Charlie Munger and himself about derivatives being 'financial weapons of mass destruction', Buffett also used terminology that is usually reserved for environmental catastrophes. Consider just these two distinct thoughts from the same letter:

"Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system."

"The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear."

When you consider that Buffett sounded the alarm well before the subprime crisis began to unravel in late 2007 and then messily exploded across the face of the planet in 2008 and beyond, his prescience seems spooky.

So, what should normal people do about those strange sounding financial instruments? Personally, I think the most important thing to do is spend time trying to comprehend what they are!

To help you get started in that regard, here are brief explanations of what derivatives, options, warrants, futures, forwards and swaps are. Trust me, if you gain a clear understanding of what each term refers to, you will be in better shape than at least 90% of the people who use them in regular conversation yet secretly hope no one will call their bluff by asking them to define the words they so blithely use!

DERIVATIVES

Derivatives are financial instruments that derive their price from the market value of an underlying asset. This underlying asset is always easier to understand than the derivative that's, well, derived from it. For instance, common underlying assets might be stocks or shares, bonds, commodities, currencies and indices.

A derivative boils down to a legal contract between two parties making a wager on the direction of price or, in the case of a currency or index, the numerical value of the relevant underlying asset.

At a micro level, the use of derivatives to hedge against adverse price movements in the underlying assets can be beneficial to an investor or business entity. In such instances, the act of hedging is exactly the same as getting an insurance policy against something going wrong with the price of the underlying asset. However, Buffett was correct in identifying the dangers associated with having so very many of these contracts being created out of thin air in recent years that the so-called cure against investment risk morphed or more like metastasised into something far more dangerous than the original 'disease'.

OPTIONS

Derivative instruments that allow their owner the right, but not the obligation, to either buy or sell the underlying investment at a set price within a specified period.

If an option grants the owner the right to buy the underlying asset, it is known as a call option. If the option grants the owner the right to sell the asset, then it is a put option.

WARRANTS

Just like options, warrants also grant their owner the right, but not the obligation, to buy or sell the underlying investment at a set price within a specified time frame. General accepted usage, however, dictates that warrants tend to be of longer duration - typically years - than options, which usually expire in a matter of weeks or months.

Another difference is that warrants generally refer exclusively to long-term options that have equities (shares) as their underlying asset.

FUTURES

Unlike options and warrants that permit the owner to walk away because he or she does not have an obligation to exercise the right to buy or sell the underlying asset at a set price within a set period, presumably because the price is unattractive, futures carry with them the obligation to settle the terms of the contract!

This legal obligation obviously makes a futures contract more risky for an investor (or gambler) to own than an option or warrant.

FORWARDS

These are clear-cut transactions that have predetermined prices for items that only need to be delivered in the future. For instance, a fisherman might use a forward contract to lock-in a decent price for a future catch of tuna that he promises to deliver to a buyer at a future date. That date is officially called the settlement date. Because of the possible uncertainty of actual delivery of the items or the cash, appropriate collateral may need to be put up by the two parties.

SWAPS

Swap contracts are a series of forward contracts that might involve equities, interest rates, commodities or currencies.

I hope you found all that helpful in clearing up some of the uncertainty you may have been harbouring concerning those six investment terms; still, let's be honest with each other...

If you found those brief explanations and definitions difficult to grasp, then that might be a powerful indication that it would be safer for you to avoid the use of derivatives altogether. Your money is hard-earned and you would be wise to think deeply and insist on understanding each type of investment you choose to place those funds in.

Generally, in the hands of sophisticated investors, the use of a controlled quantum of derivatives as an 'insurance' hedge - in the context of defensible PI or portfolio insurance - might make sense.

Unfortunately, the out-of-control explosion of the overall derivatives market caused by greedy speculators has created a derivatives market that is monumentally bigger than the size of the global economy. Really!

One estimate places the value of all derivative contracts at over US$1.2 quadrillion. In case you didn't know, a quadrillion is one followed by 15 zeroes. The total size of global GDP, more accurately referred to as our GWP or GPP, the gross world product or the gross planetary product, is probably about US$60 trillion, which is an estimate of the total value of all goods and services traded across the planet in a year. If you need help with the arithmetic, US$1.2 quadrillion divided by US$60 trillion equals 20.

This suggests the current notional value - even if 'value' remains a dubious term for what Buffett has called financial weapons of mass destruction - of all outstanding derivatives is that of the aggregate size of the annual economies of 20 Earths lined up next to each other!

Clearly something needs to be done about the disproportionately huge size of the global derivatives market given its capacity to disrupt the planetary economy. But what's just as clear is that it is eminently unlikely that anyone reading (and especially the one writing) this simple little article is going to be able to do anything about this out-of-control cancerous growth!

My suggestion, therefore, is for you to stay focused on investing in real assets such as direct or indirect ownership in businesses through equities, ownership in viable loans through bonds, actual cash or near cash instruments through money market funds, brick-and-mortar real estate, and soft and hard commodities, including tangible stores of value like physical gold and fertile farmland and, far more importantly, in intangible ones like your store of useful knowledge.

Toward that end, and in closing, to help you invest wisely in non-derivatives here's a FREE eReport I wrote on two valuable investing strategies, dollar-cost averaging (DCA) and value-cost averaging (VCA), which you may use in building a portfolio of mutual funds, unit trust funds, stocks, precious metals or, if you're sufficiently well-heeled and so inclined, rental properties.

(If you live in Malaysia AND believe you might require my help in the realm of financial planning and retirement planning, you're also welcome to learn more about me here.)

© Rajen Devadason