By DAVID MOON, Moon Capital Management,
October 26, 2008
An email is floating
around that offers alternative definitions of various investment terms. Examples
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
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
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
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
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
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).