Derivative (de-riv-a-tive) noun: a thing produced from another source
Here is a great story used to describe how derivatives were used in the financial markets. I know derivatives also played a part in this crazy financial mess we are in now, at least in some small part.
Joe goes to the track and bets $2 on a horse. Two guys standing nearby get into a discussion and Fred says to Sam, “I’ll bet you $5 that Joe wins his bet.”
Next to them are Bill and Bob. Bill says: “I’ll bet you $10 that Fred welshes on his bet if he loses.”
Next to them is Sally. Sally says: “For $3 I’ll guarantee to Bill that if Bob fails to pay off, I’ll make good on the bet.” Sally then goes to Mary and borrows the $7 needed in case she has to ever pay off and promises to pay back $8. She doesn’t expect to ever have to pay since she believes Bob will always make good. So she expects to net $2 no matter what happens to Joe.
A quick calculation indicates that there is now 2+5+10+3+7 = $27 riding on the outcome of the horse race.
Question: how much has been “invested” in the horse race?
Answer: $50,000 by the owner of the horse who is expecting to recoup his investment from the winnings of the horse and other future deals. Everyone else is gambling, not investing.
Thanks to Paul Douglas Boyer at www.MadMoneyMachine.com on turning me onto this.