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"Derivative" Is Not a Dirty Word


Two things most people consider beneficial are essentially these types of products.

As I sit here trying to find value in the convertible-bond market for my clients (it's there, but it's a lot more challenging to find than it was a year ago), I'm struck by a couple of the pieces of information overload I'm taking in.

One is a commentary I was just watching on Buffalo Wild Wings (BWLD) on one of the financial networks. Now, I usually keep the sound off (I share an office with someone who spends most of his day talking to customers), so I had to kind of guess what the point of the TV segment was.

And then I remembered a discussion I had with my students in a derivatives course I taught 10 years ago at Yale. The point of the course, to me, was to help students who might be going into public policy gain an understanding of what derivatives are really all about. They've been sporting a scarlet "D" for years, if not decades, in the financial press. In fact, if you're not careful, you might think the term "derivatives" has had the epithet "toxic" legally and surgically attached.

I titled the discussion in the Yale course "Insurance and Chicken Parts." The point was to show that two things most people generally regard as socially beneficial are essentially derivative products.

Insurance, after all, only pays off based on what happens to some underlying asset. In other words, it's a derivative.

Chicken parts are a bit different. But the process of slicing and dicing -- so maligned these days in the world of mortgage-backed securities -- is essential to the production and selling of chicken parts. Otherwise, no matter what part you want, you'd have to buy the whole chicken. Similarly, no matter what your view on a company or market, you'd have to buy only the most basic of securities without derivatives.

Now, derivatives get problematic when you start using leverage to buy them, need to sell them at any given point, and rely on constant, perfect market functioning. But the concept still makes sense.

I just thought it was a good time for a reminder.
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