Derivatives Defined. Thrice.
The The Wall Street Journal catches an embarrassing slip over at the Securities and Exchange Commission: A press release they put out quotes their Los Angeles office director referring to "derivatives" when she meant "securities." Yipes. It's all the worse because the SEC doesn't have the authority to regulate derivatives, even though that appears to be what some of its employees think the agency is doing.
Felix Salmon, as is his style, decides this to be a teachable moment and offers a quick line on the difference between securities and derivatives:
the line between securities and derivatives is quite easy to understand: derivatives are a zero-sum game, while if a security goes to zero, no one else makes a concomitant profit.
Another way of saying that is that securities represent financial value. A share of common stock, say. If the firm goes bankrupt, the stock is worthless. Derivatives -- think a credit default swap on whether the New York Times will go bankrupt -- tend to be a bet on an outcome, and if one party loses, the other gains.
For a longer -- and very useful -- introduction to credit derivatives (like credit default swaps and collateralized debt obligations, both of which had a particularly central role in this crisis), read this paper by David Skeel and Frank Partnoy. But since a lot of you won't read the paper -- and shame on you! -- I'll quote their definition of credit derivatives, too: "credit derivatives [are] financial instruments whose payoffs are linked in some way to a change in credit quality of an issuer or issuers."
June 2, 2009; 11:16 AM ET
Categories: Financial Crisis
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