Derivative Part1

    Actually, I don't want to talk about this topic to the investor who have just started investing owing to its complexity. Initially, we don't need to invest in derivative directly, but you might not believe me how the derivative indirectly affects our life in many aspects. For instance, the borrowing rate, such as mortgage and auto rates, in fact, derives from the derivative market; especially from "LIBOR" (London Interbank Offered Rate). Even the exchange rate market is derived from the derivative market too. If I move on without mentioning about this topic, it will be confused when I talk about this topic in some articles. So, I will lightly touch about derivative here.

    The derivative product is the product that its value derives from other assets (e.g., stock price, gold value). I will give you some example to clearly see what I mean.

Example: Today, we have two options to choose.

1. Wal-Mart Stock
2.Wal-Mart Stock derivative

    They seem similar but the main difference is Wal-Mart stock is the "real" stock. The second option is not a "real" stock, but its value is linked with the Wal-Mart Stock......Why do we need the unreal though?......The answer can be very broad because the derivative has multi purpose depended on the user. However, generally, the purpose of derivative is to find the "market equilibrium" or "hedge". It is the ideal purpose because in the real world we don't know whom market equilibrium is for. Like I said, due to the complexity of this market, some well-known financial institutions take advantage of this market by manipulating this market without anyone knowing. Nowadays, SEC is still investigating this market closely because of the several frauds in the past.

    Let's come back to the example. In this case, I will assume that the reason for the derivative is that there is the regulation that foreign investor cannot hold the Wal-Mart stock greater than 49%. However, the demand for Wal-Mart stock from foreign investor is much higher than that, so a financial institution tries to fulfill the demand by creating Wal-Mart-stock-like product (derivative). While the real Wal-Mart stock moves up or down, the Wal-Mart derivative will move up or down with nearly the same proportion (not perfect portion because of timing and fee)

   Next article, we will explore how many major types of derivative!