When you hear most people talk about the causes behind the Great Recession and the 2008 financial crisis the thing that many people point the blame to is derivatives. But when asked what exactly a derivative is, we are met with stutters and stammers. In a few words, a derivative is a bet on a bet.

noun

1. something that is based on another source.

In the world of finance it's a contract that derives it's value not from itself but based on the performance of an underlying asset. The price of the security is based from one or a group of underlying assets, such as stocks, bonds, commodities, currencies, interest rates, and even market indices. The derivative itself is nothing more than a contract between two parties, with the value being determined by the fluctuations in value of its underlying asset or asset group.

Legend has it that the original derivative contract was between Aristotle and Thales over an olive transaction, and Aristotle wound up on the profitable end of the deal.


One of the most attractive aspects of derivatives is the flexibility in their structuring. Because the contract does not involve the purchase or holding of an actual asset, terms can be completely modified as the parties see fit. You simultaneously relieve yourself of ownership of an actual asset, while still being able to play in the market. There are a plethora of types of derivatives for all suits and purposes. In some cases derivatives can be used to speculate the price of an asset, hedge against risk on an asset, or circumvent issues with exchange rates.

The majority of derivatives on the market are traded OTC - or Over The Counter. These are unregulated, and typically present a greater risk to the counterparty than do standardized derivatives. Standardized derivatives are regulated and traded on an exchange.

There are however certain risks and criticisms attached to derivatives. Too much hidden tail risk and a in a phenomena known as "phase lock in" your hedged position can become unhedged at the worst moment, overnight. The double edged sword in the attractiveness of derivatives lies in leverage. Because of leverage an investor can use derivatives to turn a small amount of money into large returns rather quickly. However, just as quickly one can suffer losses far greater than one's initial deposit, often greater than one can repay.

An impressive collective $39.5 billion was lost in the past decade by banks such as AIG.


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The Federal Reserve sets the guardrails for the federal funds rate, and through that helps control the money supply for the nation.

When you take out a loan for a car, charge something to your credit card, or get a personal line of credit, there is going to be an interest rate that applies to your loan.

A lot of different factors go into what you will be charged, including your own personal credit score. But even those with flawless credit still see a minimum charge that they can't get around. That all goes back to the Federal Funds Rate.

One thing consumers rarely realize is that all of our banks are lending money to each other every night. Banks are legally required to maintain a certain percentage of their deposits in non-interest-bearing accounts at the Federal Reserve to ensure they have enough money to cover any withdrawals that may unexpectedly come up. However, deposits can fluctuate and it's very common for some banks to exceed the requirement on certain days while some fall short. In cases like this, banks actually lend each other money to ensure they meet the minimum balance. It's a bit hard to imagine these multibillion-dollar financial institutions needing to borrow money to tide them over for a bit, but it happens every single night at the Federal Reserve. It's also a nice deal for those with balances above the reserve balance requirement to earn a bit of money with cash that would normally just be sitting there.

The Federal Reserve The Federal Reserve


The exact interest rate the banks will charge each other is a matter of negotiation between them, but the Federal Open Market Committee (FOMC) (the arm of the Federal Reserve that sets monetary policy) meets eight times a year to set a target rate. They evaluate a multitude of economic indicators including unemployment, inflation, and consumer confidence to decide the best rate to keep the country in business. The weighted average of all interest rates across these interbank loans is the effective federal funds rate.

This rate has a huge impact on the economy overall as well as your personal finances. The federal funds rate is essentially the cheapest money available to a bank and that feeds into all of the other loans they make. Banks will add a slight upcharge to the rate set by the Fed to determine what is the lowest interest that they will announce for their most creditworthy customers, also known as the prime rate. If you have a variable interest rate loan (very common with credit cards and some student loans), it's likely that the interest rate you pay is a set percentage on top of that prime rate that your lender is paying. That's why in times of low interest rates (it was set at 0% during the Great Recession), a lot of borrowers should go for fixed interest rate loans that won't increase. However, if the federal funds rate was relatively high (it went up to 20% in the early 1980's), a variable interest rate loan may be a better decision as you would be charged less interest should the rate drop without the need to refinance.

The federal funds rate also has a major impact on your investment portfolio. The stock market reacts very strongly to any changes in interest rates from the Federal Reserve, as a lower rate makes it cheaper for companies to borrow and reinvest while a higher rate may restrict capital and slow short-term growth. If you have a significant portion of your investments in equities, a small change in the federal funds rate can have a large impact on your net worth.

Getty Images/Maria Stavreva

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