What are Derivatives?

 

 

A stock derivative is a financial instrument that contains a value based on the expected future movement and prices of the asset to which it represents or is linked to. The assets in a stock derivative are stocks; however, a derivative in general can take the form of any financial instrument included currencies, commodities, and bonds.

 

 

Derivatives, because of their complexity and uniqueness, are referred to as “alternative investments.”

 

 

A derivative, on its own, possesses no value; however, the more basic types of derivatives are traded on markets before their expiration date as if they were generic assets.

 

 

Relationships and Characteristics of a Derivative

 

 

Derivatives are categorized by the following relationships and characteristics:

 

 

1.    The relationship between the underlying equity or asset and the derivative itself, meaning the nature of the contract i.e. swaps options or forwards.

 

 

2.    The type of underlying asset that is being exchanged (i.e. foreign exchange derivatives, interest rate derivatives, commodities, credit derivatives, or equity derivatives. 

 

 

3.    The market in which the derivative is exchanged and transacted (i.e., over-the-counter derivatives or exchange-traded derivatives.

 

 

4.    The pay-off profile attached to the derivative.

 

 

5.    The characteristics attached to the derivative, meaning is the derivatives vanilla or exotic in nature?

 

 

Why are Derivatives used?

 

 

Derivatives may be used for a variety of reasons; however, investors will commonly take part in these forms of transactions for the following reasons:

 

 

1.    Derivatives provide leverage so that a small movement in the underlying value of the asset can create a large difference in the value of the derivative contract.

 

 

2.    Derivatives enable investors to speculate and generate a profit from the transaction if the value of the underlying financial instrument moves the way that they expect. For example, investors commonly purchase or take part in a derivative agreement based on a notion that a stock moves or stays in or out of a specific price range.

 

 

3.      Derivatives are commonly used to mitigate or hedge risks of an underlying asset. By purchasing or entertaining a derivative contract an individual can obtain both side of a value move, meaning they can play the opposite direction to their previously position to cancel some or all of their exposure to a given financial investment.

 

 

4.    A derivative will also help obtain exposure to the underlying financial asset where it is not possible, in normal circumstances to obtain such a right. For example, investors can partake in weather derivatives.

 

 

5.    A derivative contract also offers the ability for the investor, where the value of the derivative contract is linked to a specific condition or event. 

 

Insider trading is one of the most prominent and notorious methods of Securities Fraud, in which individual brokers or investors are made aware of unauthorized and privileged information with regards to an investment opportunity; typically, this information is not only unavailable to the general public, but is indicative of potential increases or decreases with regard to that company’s stocks:

The term ‘Insider Trading’ is structured as per the inclusion of the word ‘Insider’, which conveys a setting – albeit illegal – in which only presumably privileged  individuals are party to information involving the trade and exchange of stocks.

Insider Trading typically results in preemptive investment activity resulting from privileged – albeit illegal and unlawful information – on the part of those party to the information in question.

In many cases with regard to Insider Trading, an individual involved with a company whose stock is publically traded will share – or sell – information with regard to an event involving the company in question that is expected to drastically alter the behavior of the company’s stock; resulting in opportunities granted in an unlawful and unethical nature to other individual investors.

The true damage of this knowledge takes place outside of the knowledge of the general populace, allowing unfair advantages to the select few privy to the information provided by Insider Trading.

Due to the fact that Insider trading involves the illegal application of information not available to the general populace, the information is garnered from an inside source and can be applied in order to render profit and benefit in investment endeavors. In the event that Insider Tradingoccurs in tandem with Microcap Fraud – a nature of securities fraud occurring as a result of the unlawful regulation of a stocks behavior resulting from mass-selling or purchase – substantial damage can take place:

Due to the decreased price latent within Microcaps – or ‘Penny Stocks’ – a large amount of these stocks can be accessed and subsequently released; as a result, a single individual or entity is afforded the prospective opportunity to control the perceived behavior of that particular stock.

In the case of Microcap Fraud fostered by Insider Trading, an individual – or individuals – may conspire with each other with regard to investment endeavors; collectively, these individuals may secretly agree to conduct mass-purchases or mass-sales of an individual stock, which allows them an unfair advantage with regard to subsequent gains or losses resulting from this activity.

The investigation of commercial operations believed to be conducting Insider Trading activity is undertaken by the Security and Exchanges Commission (SEC), which is the governmental agency responsible for all maintenance of legality with regard to the collective operations and lawful facilitation of activities rooted in securities and investment. The SEC has been responsible for a multitude of investigation involving the discovery of Insider Trading activity; some of which have involved some of the most notorious and noteworthy circumstances – the following include famous Insider Trading investigations, which resulted in criminal prosecution:

         Albert H. Wiggin; Chase National Bank Insider Trading Scandal (1929)

         Dennis Levine; Nabisco Insider Trading Scandal (1986)

         Martha Stewart; ImCloneInsider Trading Case (2003)

         Jeffrey Skilling; ENRON Corporation Insider Trading Case (2004)

         Robert Moffat; New Castle Funds Insider Trading Scandal (2010)

An escrow is a type of arrangement where a third party (typically independent and entrusted) receives and subsequently disburses finances or legal documents to two or more underlying parties aligned with the escrow. The escrow contains contractual provisions, which will state that the third party must deliver the funds or documents at a specified time.

An escrow account is typically established to hold separate funds for the purpose of paying primary bills, such as property taxes, an individual’s homeowner’s insurance, or an insurance premium. The third party, who holds the funds, will subsequently deposit the individual or entity’s funds into the escrow and then use that money to pay monthly bills when they are due. The escrow thus, effectively eliminates the probability of late payments or any issues where additional cash is needed.

The holder of the escrow, will take the annual amounts for the aforementioned bills, divide them by 12, and subsequently establish the payment amount that is then added to the individual’s monthly principal and interest payment. For example, if an individual’s homeowner’s insurance annual premium is $500, their monthly payments are roughly $41. When the bill is due, the holder of the funds will be made available since the money is already placed in the escrow account.

The individual will receive an escrow statement which will explain how the monthly escrow portion of the payment was calculated. Additionally, the escrow statement will estimate the annual expected costs of the individual’s bills. The escrow statement is received annually. 

An escrow generally refers to the funds held by the third-party on behalf of the individual placing the monies in the account. In the United States, an escrow account is best known in the context of real estate; escrows are typically aligned with mortgage payments. In this relationship, a mortgage company will establish an escrow account to deliver funds to the underlying individual to pay property taxes and the insurance policy aligned with the particular mortgage agreement.

Escrow companies are also used in the transfer of valuable assets such as property, both in the real and intellectual sense. As is common with a traditional escrow account, an Internet escrow functions when an individual places money in the control of a licensed and independent third party to help protect the buyer and seller in a specific transaction.

A banking escrow is commonly used in automated teller machines and other forms of vending equipment. In a traditional sense, an ATM is a type of escrow, where a tangible machine holds an individual’s money and is dispersed to the holder when he or she successfully enters the PIN.

Escrow can also be evaluated in a judicial context. These escrow funds are commonly used to distribute funds from a cash settlement in a class action suit or an environmental enforcement action.

The escrow is established when the buyer and seller agree to the terms outlined in the escrow agreement. The contractual agreement must establish a description of the merchandise being exchanged, the sale price, the shipping information of the funds and the number of days listed for the buyer’s inspection.

Once the contract is agreed upon, the buyer must submit an available payment option to the escrow holder. When payment is verified, the seller is then authorized to ship the merchandise and submit tracking information to ensure that the buyer will receive the shipment.

The buyer will then establish a number of days for inspection or review and institute an option to accept or reject the delivered merchandise. The escrow will then pay the seller by the method selected and where transaction will be affirmed.

A finance calculator is a common resource made available by all lending institutions, banks, or financial companies. The term “financial calculator” is a broad term used to describe all devices that will evaluate and forecast the fundamentals and pertinent numbers aligned with a loan agreement, an individual’s particular finances, or a number of other financial agreements.

A financial calculator is offered to the general public to streamline an individual or entity’s financial state; the financial calculator will organize an individual’s payments as they coordinate to a specific financing plan or loan obligation.

Although a finance calculator can be used for an assortment of financial matters, the most common types of the device are used to organize and elucidate upon an individual’s mortgage, their refinancing plan (if applicable) or the monthly payments of a particular loan.

A finance calculator is a vital resource for many individuals (particularly those who take-out loans) because the device enables an individual to determine the monthly payments on a loan, as well as how each payment affects the principal and the interest portion of the particular loan.

Additionally, a finance calculator will evaluate the expected maturity date of the loan; such a feature enables the individual to appropriately balance their budget as it pertain to their loan obligation. Although these benefits could be realized through a manual approach, the finance calculator streamlines the delivery of such information.

In addition to borrowers, a finance calculator is also utilized by lenders of various industries. For instance, mortgage loan officers and other lending professionals who are responsible for approving or establishing loan offers will use a finance calculator to evaluate the prospective borrower’s ability to repay the loan.

To evaluate a borrower’s ability to repay a loan contract, the lender will enter the specifics of the loan (the maturity date, the attached interest, the amount financed, and the expected monthly payments) against the individual’s monthly income, expenses, occupation and their credit history. When this information is submitted into a finance calculator, the device will organize the individual’s expected ability to meet the loan obligations as it pertains to the prospective borrower’s monthly income and expenditures.

The finance calculator is a simple, yet highly-beneficial tool. Although there are a number of finance calculators, the typical device will ask for the specifics of the individual’s loan agreement (interest rate, term, amount financed etc.), and their monthly income. This basic information may fluctuate based on the type of finance calculator being used; however, these two categories are the primary inputs necessary for a finance calculator.

•    Car loan finance calculator

•    Mortgage Calculator

•    Refinancing Calculator

•    Basic Loan Calculator

•    Credit Cards and Debt Management Calculator

•    Investment Calculators

•    Retirement Savings and Planning Calculators

•    Personal Finance Calculators

•    Insurance Calculators

•    Savings Calculators

A hedge fund is an aggressively managed investment fund that is typically open to a limited range of high net-worth investors who are required to pay a performance fee the fund’s investment professional team or investment manager.

A hedge fund is a term used to describe an investment partnership that is professionally run and managed by a licensed money manager. The fund may take the legal responsibility and structure of a limited liability company or a limited partnership so that if the hedge fund goes insolvent, the creditors attached to the fund cannot seek more money from the investors than what was originally put into the fund.

Every hedge fund possesses its own investment strategy that will determine the investment approach the fund undertakes. As a general class, hedge funds will institute a strategy to incorporate a wide range of investments and trading activities when compared to traditional long-only investment funds. The wide range of investments is meant to mitigate risk through the adoption of “hedging” techniques. A typical hedge fund will invest in a broad range of assets including long and short positions, bonds, commodities, and currencies. Additionally, to institute a “hedge” the funds will also incorporate complex strategies that include exotic derivatives.

Hedge funds typically pool millions or billions of investment dollars and the gross assets of the underlying fund will typically be higher due to leverage. As a result, hedge funds dominate certain specialty markets such as the derivatives sector through the institution of high-yield investment instruments and distressed debt.

Although hedge funds develop and maintain a specific strategy, there are four predominant strategies (global macro, event-driven, relative value, and directional) by typical hedge funds. The particular investment strategy will shape the fund’s risk and return characteristics. The most common strategy instituted by a hedge fund is the “long/short” strategy, where the fund will take both long and short positions in equity shares traded on major exchanges.

In the majority of jurisdictions in the United States, hedge funds are open to a limited pool of investors. Typically, the investors are comprised of wealthy professionals who meet the criteria established by the regulators of the funds. Upon meeting the regulations (primarily a minimum investment) the investors are accordingly exempted from the regulations that commonly govern ordinary investment funds.

Hedge fund managers will receive either a performance fee (or an incentive fee) along with a management fee. A typical hedge fund manager will charge a “2 and “20 fee, which refers to a management fee of 2% (taken from the fund’s net asset value each year) and a performance fee of 20% (which is charged based on the fund’s profit).

As is common with other forms of investment funds, the management fee of a hedge fund is calculated as a percentage of the fund’s net ass value. The management fees tied into a hedge fund are typically expressed as an annual percentage; however, they are most commonly calculated and paid out per month or quarter.

The management fees associated with a hedge fund is meant to cover the manager’s operating costs, while the performance fees are used to pay out employee bonuses.

Performance fees are a defining characteristic of a hedge fund. The manager’s performance fee is calculated based on a percentage of the fund’s profits, typically counting both unrealized and realized profits. By awarding the manager additional funds for the performance of the fund, performance fees intend to alight the interests of both the investor and the manager of the fund.

Investment securities are tangible certificates or documents that indicate ownership or interest in a business, asset, debt instrument, or government entity.

There are two common types of investment securities: debt securities (such as bonds, Collateralized debt obligation, mortgage-backed securities, or debt-issued derivatives) and equity securities (such as common stock or options).

Investment securities may be purchased on a market place or an alternative listing (such as the Pink Sheets or Over-the-Counter) with the fundamental purpose of earning a profit. Individuals, businesses, or government entities will purchase investment securities to diversify their funds and attempt to generate a profit following the sale of their particular investment security.
Debt Obligation Investment Securities:

A debt obligation investment security is a type of financial instrument where the investor purchases a form of debt from the issuer. Bonds, which are the most common form of debt obligation investment security, are issued by corporations, municipalities, or government entities. When an individual or business entity purchases a bond from the aforementioned issuers they are in essence lending the institutions money for the promise that the issuer will recoup the principal investment in addition to interest payments. The money obtained through the issuance of a bond is used to finance expenditures and provide public services. In turn, the investor will make a profit off the bond (assuming the issuer doesn’t default) through the obtainment of coupon payments.

Bonds are issued with varying maturity dates, coupon payments, and interest rates. Regardless of the specifics associated with the investment security, all bonds are considered debt-instruments that are supplied by the issuer to raise money and are purchased by the investor to earn a profit through the obtainment of interest payments.

Other forms of debt obligation securities include: Treasury Bonds, Treasury Bills, General Obligation and Revenue Bonds, Participating bonds, Zero Coupon Bonds, Convertible Bonds, Treasury Notes, High Yield (Junk) Bonds, Indexed Bonds, Mortgage Backed Securities, Warrant Bonds, Sinking Bond Funds, and Commercial Paper.

Investment Securities that take the form of equity are typically purchased as shares, which represent partial ownership in a publicly-traded company. The investment in such a company will earn a profit if the stock price exceeds the investor’s purchase price. The following examples are regarded as equity investment securities: common stock, par value, book value stocks, dividends, ex-dividends, treasury stocks, depository receipts, DRIPS, commodities, and varying classes of stock.

In addition to generic stock purchases, investors may purchase derivatives, which are financial instruments that are connected to their underlying security.

A stock market crash refers to any dramatic and excessive decline of stock prices across a significant section of the stock market. Such a precipitous drop contains numerous negative externalities that are tied into the significant loss of paper wealth.A Stock market crashmay be fueled by an assortment of economic factors such as the collapse of the credit market, hyperinflation, the ‘bursting of a bubble’ (housing or .com for example), a global event (such as a terrorist attack), sharp fluctuations in the prices of commodities, failed or a lack of regulations, etc.

Although an event (such as the ones described earlier) is typically needed to cause a precipitous drop in the prices of stock, panic among investors is the primary characteristic to fuel a stock market crash. When investors follow a herd mentality by executing mass-sales (typically executed when confidence is low or individuals are fearful of losing their wealth) the prices of stock invariably tumble. Such an event sparked the Great Depression, where the majority of investors (due to a lack of information and over exposure to the markets) all sold their positions with reckless abandon.

Some economists describe a stock market crash as social phenomena where external economic events combine with crowd psychology to negatively affect the macro-economy. Typically, stock market crashes take place following these conditions: a prolonged period of rising stock prices and excessive investment into the market generated by an overwhelming sense of economic optimism, a market where price to equity rations exceed long-term averages, or when extensive use of debt is used by market participants. 

There is no numerically significant decline that is needed to define the presence of a stock market crash; however, the term is typically attached to economies that experience double-digit percentage losses in a given stock market index over a period of several days or weeks. Stock market crashes are distinguished from bear markets or common recessions based on the severity of decline experienced.

Bear markers are defined as periods of steady declines in the prices of stock that take place over months or years; as a result  of the extended length, bear markets and stock market crashes, although portray a significant decline in the price of stocks, are not held synonymously.

A money market account is a unique type of savings account offered by credit unions and commercial banks. Although a money market account is offered like a regular savings account, the primary difference between the two saving strategies is that money markets are attached with higher interest payments and require a higher minimum balance to avoid monethly fees. Additionally, the typical money market account will only allow an individual or entity to withdraw monies from the account 3 to 6 times per month.

Another difference between a money market account and a typical savings account is that, similar to a checking account, the majority of money market accounts enable the investor or saver to write up to three checks per month. The checks issued, will debit monies directly from the money market account similar to a typical checking account.

Similar to bank accounts, the monies kept in a money market account are insured by the Federal Deposit Insurance Corporation (the FDIC). This insurance policy offers protection to the investor even if the underlying bank or credit union goes bankrupt or insolvent.

What does a Bank or Credit Union do with your Money?

Money market accounts are deposit accounts offered by banks or credit unions. The money kept by a bank account or credit union is then subsequently invested in corporate and government securities. In turn, the money market account and the coordinating bank or credit union will pay the depositor interest according to the current interest rates in the money markets.

Similar to a Negotiable Order of Withdrawal Account, a money market account is structured in accordance with Regulation Q, which forbids paying interest on generic checking accounts. As a result, money market accounts bear interest, and enable the depositor to write checks; however, due to various restrictions, money market accounts are not legally viewed as checking accounts.

Since a money market account is not viewed as a transaction account, the investment option is subject to the regulations on saving accounts, primarily the restriction that impedes a depositor from accessing more than 6 withdrawals to third parties per month. Banks or credit unions will discourage depositors from exceeding such limits by imposing high fees or by closing their accounts.

The FDIC is an independent agency of the United States Federal Government that was created in 1933 as a result of the multitude of bank failures due to the economic boom of the 1920s and the subsequent collapse of the economy during the Great Depression. Since the FDIC’s creation, not a single person has lost money by keeping their money in a bank or credit union that was insured by the FDIC.

The monies kept in a money market account with a credit union are insured by the National Credit Union Administration.

A mutual fund is a professionally managed collective investment strategy that pools money from multiple investors for the mass-purchase of investment securities. Mutual funds–which are typically comprised of stocks, short-term money market instruments, bonds, commodities, other mutual funds, and other securities—are popular investment options due to their enhanced strategy and their ability to diversify risk through wide-spread investment of multiple industries and sectors.

A mutual fund is managed and run by a fund manager that trades (actively buys and sells) the fund’s investments in accordance to the fund’s overall investment strategy or objective.

In the United States, all mutual funds are registered with the Securities and Exchange Commission (SEC) under both the Internal Revenue Service (IRS) and SEC’s regulations. As a result of this adherence, all mutual funds that are formally created in the United States must distribute nearly all of its net realized gains and net income from the sale of their securities to its investors. The distribution of gains and income must be awarded to those individuals who invest in the fund (who deliver funds to the manager for the right to buy and sell securities) at least annually.

The majority of funds in the United States are overseen by a group of managers or by a board of directors. As a result of this structure, the board, along with the investment adviser and other service organizations, is primarily responsible for ensuring that the fund is managed appropriately and in accordance with the bylaws of the fund’s investment objective. Regardless of the fund’s organizational structure; however, all mutual funds must manage their investments based on the best interest of the fund’s investors.

Since the passage of the Investment Company Act of 1940 and the Investment Advisers Act of 1940, there have been three general types of registered investment companies in the United States of America: open-end funds (mutual funds), closed-end funds and unit investment trusts. Recently; however, this classical interpretation of an investment company has evolved to include novel types of investment strategies, such as exchange-traded funds and hedge funds.

Open-ended Funds

The term “open-ended fund” simply means that at the end of every trading day, the mutual fund will continually issue new shares to potential investors who will buy into the fund and must be ready to buy back shares from investors redeeming their shares at the present net asset value per share.

Mutual funds are structured as corporations or trusts, such as business trusts. Any corporation will be classified by the Securities and Exchange Commission as an investment company if the fund issues securities and predominantly invests in non-government securities. An investment fund will be classified as an open-investment company by the SEC if the fund does not issue undivided interests in specific securities and if it issues redeemable securities.

Mutual funds in the United States must use SEC form N-1A to report their average annual compounded rates of return for 1-year, 5-year and 10-year timeframes; the average annual compounded rates elucidate upon the average annual total return of the fund.

The following formula is used to calculate the average annual total return of a mutual fund: P (1+T)^n=ERV where P=a hypothetical initial payment; T=the average annual total return; and N=total number of years.

The fee structure associated with a mutual fund is divided into two or three components: non-management expenses, management fees, and the fees associated with 12b-1/non-12b-1 fees. All expenses associated with a mutual fund are expressed as a percentage of the average net assets of the fund.

Online stock trading is a form of self-direct investing that allows an individual investor to partake in the buying and selling of stocks or options through the use of an internet marketplace or platform.

As a result of the rapid-pace, low-commissions, minimal fees, and overall ease of access, online stock trading has become the norm for individual traders and investors. Due to this popularity, the majority of brokers no offer online services that contain unique trading platforms to expedite online stock trading.

Benefits of Online Stock Trading:

Before online stock trading was made available, investors had to call up their hired brokers and place their particular orders over the telephone. The broker would take the order and execute the trade by placing the order into their system, which was directly linked to the coordinating trading floors and exchanges. With the advent of the Internet; however, investors are now able to execute instant trades with other investors via electronic communication networks. Although some orders entered through the Internet are still routed through the broker, the process of online stock trading is exceptionally faster than the prior technique.

The majority of online stock trading must be approved by agents who monitor the trades. This fundamental step assists in the protection of both the brokerage firm and the client from unlawful or incorrect trades.

Prior to online stock trading the fees associated with executing a trade through a tangible broker was exorbitant. The majority of online brokers are referred to as discount brokers, because the same fees associated with physical brokers are exceptionally lower when executed online. The fees attached to online stock trading are lower due to the speed in which the trade is executed (exponentially more trades can be executed) and online stock trading does not deliver investing advice that is commonplace with a generic broker.

Risks Associated with Online Stock Trading

Before you choose to invest or take part in online stock trading, it is essential that you adequately research the online broker that is being utilized. You must assure that the online broker is licensed with the coordinating state or provincial jurisdiction in which the online stock trades are executed.

The Federal Government of the United States provides tips to avoid investment scams through the issuance of their On Guard Online website.

Potential investors must also understand the potential risk of investing without the aid of a licensed and trained Stock Broker or Investment Professional. These individuals are well-versed in trading and understand the compliance issues associated with investments. Forgoing this information and knowledge could prove costly. As a result of this, the majority of online stock trading companies or online brokers will offer a number of investment tools that may be utilized by individuals.

Once you have researched the aforementioned information, you must research the particular sectors and the coordinating business and financial statements of each company whose stock you plan on purchasing. This knowledge, along with a diversified investment strategy will assist in mitigating the risks associated with the volatility of the stock market and the general risks associated with online stock trading.