Two questions about finance: Derivatives and Portfolio Theory

Factual Questions
1

Just like the thread title says:

  1. Could someone explain derivatives to me? I can take a little detail.

  2. If someone talks about “portfolio theory,” what are they talking about?

2

  1. A derivative is a financial instrument whose value comes from the value of another financial instrument. A futures contract is an agreement to buy some traded thing (a commodity or a cash financial instrument) for a specific price at some time in the future. The value of such a contract derives from the value of the underlying thing. This page has some payoff diagrams for various types of derivatives.

  2. Really crudely, porfolio theory proceeds from the idea that whilst individual stocks might be quite risky, a bunch of stocks will be less risky and if chosen well, can nonetheless provide a fairly high return. Remember that high risk investments are also those with high payoffs. Portfolio theory says you can get higher returns for a given overall risk by diversifying your portfolio. That is you buy a combination of high return/ high risk and low return/ low risk assets in a pattern that takes advantage of the different degrees of relatedness of various financial instruments (imperfect covariance: not all stocks move in the same direction at the same time).

3

Portfolio theory is an example of the maxim “Don’t put all your eggs in one basket.”

–Cliffy

4

Indeed. Perhaps coldfire or one of our other finance market mates will enlighten us further.

Not that I’m a finance guy or anything, but a small piece of advice is probably warranted: don’t fuck with derivatives markets unless you know what you’re doing. Whilst with share markets your initial stake is the most you can lose, this is not always the case with derivatives.

5

Exactly right. An individual stock’s risk can be broken into two categories: systematic and unsystematic risk. You’ve just got to live with the first one, it affects the whole market. The second one can be diversified away based on what Hawthorne wrote about covariance. At the end of the day, with a portfolio you get the same EXPECTED return, for a lower risk, which is wonderful.