Investor's Passport to Hedge Fund Profits: Unique Investment Strategies for Today's Global Capital Markets

CHAPTER 8

Derivative Use for Offense and Defense

Many people are tempted to turn and run when they hear the word “derivatives.” One of the most famous quotes about derivatives in recent years comes from Warren Buffett, when he said that, “Derivatives are financial weapons of mass destruction,” and when the Oracle of Omaha speaks, investors listen. That said, what we intend to show you in this chapter is that derivatives can be used in a conservative fashion to hedge certain risks, which is how most hedge fund managers employ derivatives. Like many things in life, derivatives are neither good nor bad in and of themselves, but it is how they are used that determines their legacy in one’s portfolio; on that note, we are reminded of the words of Sir Josiah Stamp, president of the Bank of England in the 1920s, who said, “It is easy to dodge our responsibilities, but we cannot dodge the consequences of dodging our responsibilities.” As that quote relates to derivatives, it tells us that you can be as aggressive and as speculative as you want to be, but like John Meriwether and Long-Term Capital Management learned in 1998, you will eventually pay the consequences of not using derivatives in responsible fashion.

Okay, so what are derivatives? Many of us first encountered derivatives in mathematics courses; in calculus, derivatives are a measurement of how a function changes when the values of its inputs change, and the definition as it pertains to the capital markets is essentially the ...