Not all investors know the jargon

By DAVID MOON, Moon Capital Management, LLC
October 26, 2008

An email is floating around that offers alternative definitions of various investment terms. Examples include:

Bear market: a 6-to-18-month period in which the kids get no allowance, the wife gets no jewelry and the husband gets no affection.

CEO: Chief Embezzlement Officer

And so on.

The stock market ' especially these days ' isn't a laughing matter. But these types of emails, along with some questions I've received the past few weeks, remind me that our industry sometimes uses phrases that aren't immediately understood by every investor.

Here are some you might not know.

A derivative is an investment that derives its value from something else. It has no value by itself. A share of stock is an actual ownership interest in a company. It has value all by itself. But if I tried to sell you the right to buy Regions Financial stock at $25 a share within the next week, it wouldn't be worth very much; Regions trades for about $11 a share.

But I would probably be willing to pay nearly $6 a share to enter into a contract that would let me buy Regions for $5 a share, since I could immediately sell the shares at $11 and realize a $6 profit.

The derivatives I just described are call options. They give the owner the right to 'call' or purchase another asset at a specific price, within a certain period.

A put option works in reverse. If I own a put, I have the right to make someone else buy a stock at a particular price within a specific period.

Neither the call nor put option has intrinsic value, except as it is derived from the price of the stock on which the option is based.

Another type of derivative that's been in the news a lot lately is the credit default swap.

Hold on here; we're going to pick up a little speed.

A credit default swap typically gives the owner the right to receive money if a borrower defaults on a loan. It is like insurance against a loan default.

Here's an interesting twist, however. Imagine that some stranger was buying fire insurance on your house. This creep from Alabama is simply betting that your house is going to burn down ' and if so, he'll collect on his policy. Credit default swaps also give investors the ability to do that.

Assume Acme Widgets thinks that Wiley Corp. is in financial trouble and may go into default on some debt it has outstanding. Acme has no business relationship with Wiley. Acme could enter into a credit default swap with Rabbit Inc. whereby Rabbit would pay Acme $1 million if Wiley defaults on a loan it has outstanding to Wren LLC.

Acme thinks Wiley will default. Rabbit thinks it won't. They place a bet. That's a credit default swap.

By the way, using the word 'swap' instead of 'insurance' helps avoid regulation of these derivatives as insurance products. So did specific federal regulation passed in 2000.

What's still unclear is how they escape regulation as casino or riverboat gambling.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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