Financial terms a puzzle? read on
Among her suggestions: equities, hedge funds and derivatives. What the heck are these things, she wondered.
I figured she wasn't the only one with these questions, so I decided to devote this column to coming up with a simple-to-understand definition for each.
Derivatives: The easiest way to understand these highly complex and varied financial instruments is to look at the word itself. Derivatives are things that derive their value from some underlying asset such as a house, stock or commodity.
Sunday, April 08, 2012
By Bill Freehling, The Free Lance-Star, Fredericksburg, Va.
April 8--AREADER recently approached me with a request: Start including a glossary with this column that defines financial terms that are frequently tossed around but little understood. Among her suggestions: equities, hedge funds and derivatives. What the heck are these things, she wondered.
I figured she wasn't the only one with these questions, so I decided to devote this column to coming up with a simple-to-understand definition for each.
Derivatives: The easiest way to understand these highly complex and varied financial instruments is to look at the word itself. Derivatives are things that derive their value from some underlying asset such as a house, stock or commodity.
For example, a farmer might want to lock in the price at which he can sell his soybeans. He can enter into a futures contract that will allow him to guarantee his sales price at a certain level. If the price of soybeans goes way up, the farmer will still be locked in to the lower amount. But if the price of soybeans tanks, he will still be guaranteed the amount he locked in upfront. This is a good way to reduce his risk.
That futures contract can then be traded on the open market, and its price will go and down based on the price of soybeans. The contract itself has no inherent value. But it derives its value from an underlying asset, in this case soybeans. And hence it's called a derivative.
Many investors buy stock options for the same hedging purpose, allowing them to lock in a given price at which they can sell or buy a stock in the future. The seller of the option looks to pocket some upfront cash. Again, the option will gain and lose value based on how the underlying stock is trading. It derives its value from the stock.
These are both real-world examples of how regular people can use derivatives to hedge risk, boost their income or for some other purpose. People who trade these derivatives on Wall Street are often far removed from the underlying asset.
That futures contract can then be traded on the open market, and its price will go and down based on the price of soybeans. The contract itself has no inherent value. But it derives its value from an underlying asset, in this case soybeans. And hence it's called a derivative.
Many investors buy stock options for the same hedging purpose, allowing them to lock in a given price at which they can sell or buy a stock in the future. The seller of the option looks to pocket some upfront cash. Again, the option will gain and lose value based on how the underlying stock is trading. It derives its value from the stock.
These are both real-world examples of how regular people can use derivatives to hedge risk, boost their income or for some other purpose. People who trade these derivatives on Wall Street are often far removed from the underlying asset.
Hedge fund: Hedge funds generally have a bad name, but it shouldn't necessarily be that way. Essentially, managers of hedge funds are trying to do the same thing that mutual fund managers are doing: make money for their clients (and hence profit themselves).
But unlike mutual funds, which tend to invest in easily understood assets such as stocks and bonds, hedge funds use more complex strategies that often involve derivatives, short-selling and other things. The idea is to limit the fund's risk and allow it to perform well in all market conditions. For example if the portion of the hedge fund that's invested in stocks craters, the manager will have another asset that gains in value to offset the loss. In other words, risk is hedged. And hence the name.
Hedge funds get a bad name because they aren't as closely regulated as plain-vanilla mutual funds. They're typically restricted to only wealthy investors who presumably understand how the funds work (though many probably don't). A few bad apples in this category have given the overall asset class a black eye in the eyes of many people. But at the most basic level, a hedge fund is simply trying to avoid losing investors' money.
Equities: An equity is just a fancy name for a stock. People who own stock have a fractional stake in the company's financial results (as opposed to owners of bonds, or debt, who have just been promised a steady payout but no share of the earnings). Because you have some ownership in the company, you have equity in it in much the same way as when you put a down payment into a home. And hence the name.
But unlike mutual funds, which tend to invest in easily understood assets such as stocks and bonds, hedge funds use more complex strategies that often involve derivatives, short-selling and other things. The idea is to limit the fund's risk and allow it to perform well in all market conditions. For example if the portion of the hedge fund that's invested in stocks craters, the manager will have another asset that gains in value to offset the loss. In other words, risk is hedged. And hence the name.
Hedge funds get a bad name because they aren't as closely regulated as plain-vanilla mutual funds. They're typically restricted to only wealthy investors who presumably understand how the funds work (though many probably don't). A few bad apples in this category have given the overall asset class a black eye in the eyes of many people. But at the most basic level, a hedge fund is simply trying to avoid losing investors' money.
Equities: An equity is just a fancy name for a stock. People who own stock have a fractional stake in the company's financial results (as opposed to owners of bonds, or debt, who have just been promised a steady payout but no share of the earnings). Because you have some ownership in the company, you have equity in it in much the same way as when you put a down payment into a home. And hence the name.
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