You may have heard of everything that happened in the 2008 financial crisis. Recently, “The Big Short” – a book turned into a film – showcased the crisis down to its dirtiest details. In the movie, they talked about swaps, derivatives, structured products, credit ratings, mortgage, and other complex terms. It all boils down to a history-changing crash which led to the downfall of Lehman Brothers, the loss of many jobs, and the meltdown of a strong financially economy.
Derivatives were pivotal entities in the financial crisis. Before the 2008 financial crisis, global regulators did not create ways to lessen the risks of derivatives. After the crisis, they have built rules that will create safer environments for investors including adding centralised counterparties and margin requirements.
Now that derivatives are safer, are they still bad, scary investments? Can derivatives be good investments?
The role of risk in investments
Any kind of investment involves risks. Risks cannot be avoided and market risk is always part of a normal market condition. Though they are unavoidable, risks can still be lessened. It is also best to lessen these risks and increase rewards at the same time.
Derivatives can be good investments and used towards your favour if they are used properly. Given its natural complexity, it can also be detrimental to your portfolio. In order to lessen the risk involved in derivatives and turn them into good investments, you must know how to use it to your advantage.
What are bad derivatives?
A bad derivative, at first glance, looks like a scam. However, you must be careful. In today’s modern world, even scammers can look like legit identities.
Bad derivatives do not trade on formal exchanges with a central counterparty that regulates the trade. If you are getting derivatives straight from speculators or investment advisors, avoid it at all costs!
After the crisis, institutions lessened Bilateral Credit Risk by ensuring the involvement of centralized counterparties. With the help of central counterparties, failed trades can be lessened because if one side of the trade fails to accomplish his side, the central counterparty can step in to complete the trade.
Bad derivatives do not have the support of central counterparties. This means that there is a possibility for one side of the derivative to default on the trade, causing uncontrolled losses.
Other forms of bad derivatives without regulatory party involvement include derivatives sold through promissory notes, account receivable investments, and any type of investment which relies on future gains. These can be scams that will blatantly harm your portfolio.
How do I make derivatives good investments?
Derivatives can be good investments. Just like anything else – investment or not – derivatives can be used favourably if used properly.
If derivatives are used to hedge positions for gains, increase leverage, or speculate price movements (link to: “Derivatives – the Risks You Need to Know About), they can be good investments.
Investors who make good investments with derivatives do so by protecting their portfolios from inherent risks. By hedging positions against their losing ones, they can lessen their losses or gain net profits. With derivatives, investors also have the option of increasing their leverage, thereby increasing their possible gains as well. Lastly, derivatives that help investors mark a speculation on a contract for a specified date can help companies lessen costs and risks if they’re on the right side. All of these are ways for investors to make use of derivatives positively.
Though derivatives played a vital role in the 2008 financial crisis, they can still be good investments. However, you must remember that just like any other type of investments, market risks will always be present.
What are samples of good derivatives?
Good derivatives are those that allow investors to hedge, leverage, and speculate their positions.
Exchange-traded funds are examples of good derivatives. Long before the 2008 financial crises, they have already used central counterparties that focused on the safety of a trade and ensured that members who are obliged to pay do not default on the trade.
Mutual funds, variable annuities, variable life insurance, and investment-linked insurance policies can be considered derivatives because they rely on the value of another asset. These options are good derivatives as well. Like exchange-traded funds, they are leveraged opportunities because the money involved in these options is pooled from different investors. The best part about these investments is how they lessen risk and increase leverage at the same time because of the money being pooled.
Pooled money from many different investors allows individual investors to have a stake of a large position which they cannot usually afford if done individually. At the same time, pooled funds lessen risks because they only have to invest a little amount of money to have a stake on a large stake.
Little money at stake = lessen risk. Opportunity to join a large investment = leveraged investment.
If you can find investments that look like this, you may consider it as a good derivative investment.
Another sample would be crowd-funded real estate. Real estate has always been seen as the investment of the wealthy. However, because of technological advancements, anyone with at least US $1,000 to invest can crowd-fund real estate investments. By doing so, investors get a stake in real estate profits, like rent, without having to think about maintenances fees, landlords, and all the other real estate complications because they don’t own the properties. They only have a stake in the growth of the properties. This allows investors to lower their risks and to increase their leverage since this is also a form of pooled funds.
Derivatives can reduce losses if used properly. If abused and managed poorly, derivatives can be your portfolio’s biggest nightmare. To find good derivatives, just remember that it must do any of these things: hedge, leverage, or speculate. In addition, it must also be regulated by a central counterparty and must have room for collateral. With these in mind, you may turn derivatives into winning investments.
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