Some ETFs are derivative-like, some are not. Some ETFs are structurally doomed (UNG comes to mind); some are comparable to mutual funds (SPY, e.g.). They are difficult to generalize, functionally.

One could argue the notional principal isn’t at risk as it isn’t swapped, but counterparty risk on the daily settlment is at risk. The notional values underlying the ETN instrument based derivatives may never actually trade, thus making the variance a derived value swap.

But as several commenters above sense, this is a distinction without a difference. What matters is the nature of the underlying instrument. Otherwise you end up saying nonsensical things like, Bond Futures aren’t derivatives, because you can take delivery of the bonds, but Eurodollar futures are, because they are “side bets” (cash-settled)

If the underlying market is valid and liquid, the derivative should be meaningful, if volume in the two markets is balanced. But if there is a massive disparity in size or liquidity, as it is in the market for cash-based muni debt and the muni CDS market (to pick an egregious example), you end up with one or the other market being a video game for hedgies.

And if policy errors result from bad price signals, don’t say you weren’t warned.

Why do so many believe this? E-minis and SPY converge in price because they are near-perfect substitutes as investment vehicles. The only difference is that E-minis are discounted due to not receiving dividends. They’re very close substitutes, and economics tells us that prices and quantity of substitutes cause changes in the prices of each other.

If I want to bet the S&P 500 will go down, I have two options – either short SPY, or short E-minis. If E-minis go away, I will be more likely, and pay more in fees, to short SPY, causing the price of SPY to go down.

Likewise, if I want to bet that the S&P 500 go up, I have two options – buy E-minis, or buy SPY. If E-minis go away, I will be willing to pay higher fees to get SPY instead, and cause its price to go up.

In other words, if I own long E-minis, I have real wealth – I have claims on hedge funds who have bought SPY and shorted E-minis in order to bring their prices in line.

I lost you when you said that an ETF whose VALUE is derived from the VALUE of the S&P basket was not a derivative though… because it’s “essentially a mutual fund”? That means it can’t be a derivative I guess… well okay then.

A call option has value only becasue the price of the underlying asset is priced where traders are willing to pay something to buy the call.

SPY is not a derivative.

It’s essentially a mutual fund. SPY has value because it owns assets.

Mark
http://blog.mdwoptions.com

Is a derivative necessarily derived from another asset? No. VIX futures are derivatives by any sensible definition but realized volatility is not a traded asset and there is no replicating portfolio.

Is a derivative necessarily a bilateral contract rather than a negotiable security? No. Exchange-traded options are negotiable but they are definitely derivatives.

Is a derivative necessarily something that has no real claims on real assets? Not even close. Plenty of derivatives are physically settled with the underlying asset.

Is a derivative necessarily a side bet? Of course not. It is often attractive to structure derivatives with zero initial cost, but this is hardly a precondition. Plenty of derivatives are funded, including the ABS/CDO tranches you like to write about.

“But if you own shares of SPY, you have real wealth: real claims on real assets of 500 real companies in the real world”