What are derivatives and synthetic investments?
During the recent financial meltdown, I heard a lot about "derivatives" and "synthetic" investments. What are they, and how did they contribute to the economic downturn?
Derivatives are securities based on another security or index. For example, an option to buy a stock is based on a particular stock, but the stock itself represents ownership of a company, and so is not a derivative. A synthetic instrument is typically a security created by combining other securities to make something with risk/reward not found in a conventional security. I don't think you can say they contributed to the economic downturn, but I do think you can say that with leverage and some unanticipated market conditions, gains and/or losses might be magnified. These are good reasons why individual investors should stay away. | 03.21.14 @ 18:00
Alex, did a good job of defining derivatives but I would add that these are not things to be involved with unless you have a great deal of knowledge. The base fact is that financial engineering and derivative strategies do not eliminate risk they transfer it or disguise it. To successfully understand derivatives you have to do some second level thinking that is to say what are the consequences of this strategy beyond the ones that are obvious. The construction of derivatives often creates unseen and unquantifiable risk. | 06.22.15 @ 17:22
I would add on to what Dennis said. If you are looking for a get rich quick scheme, there isn't any despite the financial news pundits who glorify these hedge fund, derivative and private equity managers who claim to beat the market averages. Construct a low-cost diversified portfolio with index funds, with a stock bond split appropriate for your risk tolerance and when you need the money, that you understand the risk and return and stay the course. There is nothing wrong with the market averages. | 06.23.15 @ 14:27