Derivatives - how they work.

hiorta

Food for thought

Explanation of Derivative Markets, in terms we can relate to.

Heidi is the proprietor of a bar in Detroit . She realizes that virtually all of her customers are unemployed alcoholics and, as such, can no longer afford to patronize her bar. To solve this problem, she comes up with a new marketing plan that allows her customers to drink now, but pay later.

Heidi keeps track of the drinks consumed on a ledger (thereby granting the customers' loans). Word gets around about Heidi's "drink now, pay later" marketing strategy and, as a result, increasing numbers of customers flood into Heidi's bar. Soon she has the largest sales volume for any bar in Detroit .

By providing her customers freedom from immediate payment demands, Heidi gets no resistance when, at regular intervals, she substantially increases her prices for wine and beer, the most consumed beverages. Consequently, Heidi's gross sales volume increases massively.

A young and dynamic vice-president at the local bank recognizes that these customer debts constitute valuable future assets and increases Heidi's borrowing limit. He sees no reason for any undue concern, since he has the debts of the unemployed alcoholics as collateral.

At the bank's corporate headquarters, expert traders figure a way to make huge commissions, and transform these customer loans into DRINKBONDS, ALKIBONDS and PUKEBONDS. These securities are then bundled and traded on international security markets.

Naive investors don't really understand that the securities being sold to them as AAA secured bonds are really the debts of unemployed alcoholics. Nevertheless, the bond prices continuously climb, and the securities soon become the hottest-selling items for some of the nation's leading brokerage houses.

One day, even though the bond prices are still climbing, a risk manager at the original local bank decides that the time has come to demand payment on the debts incurred by the drinkers at Heidi's bar. He so informs Heidi.

Heidi then demands payment from her alcoholic patrons, but being unemployed alcoholics they cannot pay back their drinking debts. Since Heidi cannot fulfill her loan obligations she is forced into bankruptcy. The bar closes and the eleven employees lose their jobs.

Overnight, DRINKBONDS, ALKIBONDS and PUKEBONDS drop in price by 90%. The collapsed bond asset value destroys the banks liquidity and prevents it from issuing new loans, thus freezing credit and economic activity in the community. The suppliers of Heidi's bar had granted her generous payment extensions and had invested their firms' pension funds in the various BOND securities. They find they are now faced with having to write off her bad debt and with losing over 90% of the presumed value of the bonds. Her wine supplier also claims bankruptcy, closing the doors on a family business that had endured for three generations, her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 150 workers.

Fortunately though, the bank, the brokerage houses and their respective executives are saved and bailed out by a multi-billion dollar no-strings attached cash infusion from their cronies in Government. The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-drinkers who have never been in Heidi's bar.

Now do you understand?

RichardAnd

Very good example, you really explain this clearly.

woodseb

that's around 2% about derivatives and 98% about bad lending

P. Breathnach

woodseb wrote: »

that's around 2% about derivatives and 98% about bad lending

A 49:1 gearing. Now we are getting closer to the idea of derivatives.

woodseb

P. Breathnach wrote: »

A 49:1 gearing. Now we are getting closer to the idea of derivatives.

nope, leverage and derivatives are not the same thing

P. Breathnach

woodseb wrote: »

nope, leverage and derivatives are not the same thing

Not exactly the same, but with a degree of similarity. Trading in price margins is a way of concentrating risk, and has a roughly similar effect to gearing. It's a close enough resemblance for casual conversation and making frivolous comment.

Cookie_Monster

Its a good story but not really right at all.

All that is is bad loans give based on poor credit sales practice, and probably a lot of lying on someones behalf

woodseb

P. Breathnach wrote: »

Not exactly the same, but with a degree of similarity. Trading in price margins is a way of concentrating risk, and has a roughly similar effect to gearing. It's a close enough resemblance for casual conversation and making frivolous comment.

Don't think that's fair to say. Leverage in almost all cases increases risk. Derivatives can raise or reduce risk depending on how they are applied.

Interchanging these terms just leads to misnuderstanding on the concepts and frivolous threads like this

Banned Account

It's just a cut and paste article which has been doing the rounds - google the first paragraph.

What it really explains is one particular type of derivative - namely mortgage backed securitizations, it does little in the way of explaining derivatives as a whole.

woodseb

Fitzcaraldo wrote: »

It's just a cut and paste article which has been doing the rounds - google the first paragraph.

What it really explains is one particular type of derivative - namely mortgage backed securitizations, it does little in the way of explaining derivatives as a whole.

not to mention that MBS aren't technically derivatives either

synthetic CDOs are but they are a different story altogether

P. Breathnach

woodseb wrote: »

Don't think that's fair to say. Leverage in almost all cases increases risk. Derivatives can raise or reduce risk depending on how they are applied...

Risk is there, and in normal circumstances is independent of financial instruments.

Instruments are used to move risk around. They don't alter the degree of risk in the system, just where it falls.

Highly Salami

Cookie_Monster wrote: »

All that is is bad loans give based on poor credit sales practice, and probably a lot of lying on someones behalf

Sounds like the credit bubble in the West from 2002 to 2007

woodseb

P. Breathnach wrote: »

Risk is there, and in normal circumstances is independent of financial instruments.

Instruments are used to move risk around. They don't alter the degree of risk in the system, just where it falls.

however some instruments can create risk such as leverage and lending, such as lending to subprime applicants. the primary use of derivatives is to mitigate and spread risk across participants which is a positive use as long as it is priced correctly and you don't have guys like AIG insuring whatever piece of crap that was put in front of them.

gigabit

The value of worldwide derivatives is approaching 10 times the GDP of the planet.

Banned Account

gigabit wrote: »

The value of worldwide derivatives is approaching 10 times the GDP of the planet.

GDP of Planet 2009 was around $70 trillion

from Bloomberg "The total amount of over-the-counter contracts whose value is derived from price changes of bonds, currencies, commodities and stocks, or events like interest rates or the weather rose 39.5 percent to $415 trillion, the biggest jump since the BIS began compiling the data. "

and

"The actual money at risk through credit derivatives increased 93 percent to $470 billion last year, the BIS said. The amount at stake in the entire derivatives market is $9.7 trillion, according to the BIS, which was formed in 1930 to monitor financial markets and regulate banks."

So not as bad as one may be led to believe - 90% of statistics are made up on the spot;)

http://www.bloomberg.com/apps/news?pid=20601087&refer=home&sid=aYNwwkZ3PLdQ

P. Breathnach

woodseb wrote: »

however some instruments can create risk such as leverage and lending, such as lending to subprime applicants.

I don't see it that way. Bad lending is just that: loans given to people where the level of repayment is inadequate. It's not created by financial instruments. The problem was that a market was created where people could buy and sell bad product.

the primary use of derivatives is to mitigate and spread risk across participants which is a positive use as long as it is priced correctly

That's a rationale that I accept. I might use currency futures to take the exchange risk out of an international transaction -- in effect, transferring risk to somebody else. The futures trader, unless foolish, will have made many deals to buy and sell, priced so as to yield a profit no matter how spot values change. Fine and dandy: currency futures as a form of insurance.

But ...
If I am not hedging, and buy or sell futures that I do not have a practical use for, but because of my estimation of how the market might move, then I am speculating. And, let's face it: the market is dominated by speculators. My concern is that the volume of speculative trades is so large that it can distort a market that exists for the more humdrum purpose of facilitating commercial transactions.

And if people are allowed play the market without having the means to fund all losses that might arise, then they can bring things crashing down (ask Sean Quinn about this).

That's a problem with markets: they become the playgrounds of gamblers, and can get seriously distorted. Delayed settlement is the key: you don't find significant speculation in the fish market or that for fresh fruit & vegetables.

and you don't have guys like AIG insuring whatever piece of crap that was put in front of them.

I haven't studied it closely, but I understand that it was all based on a mathematical model that made risk disappear in a puff of smoke. Sometimes what is needed is a bit of hard-headed common sense, and that seemed not to have found its way into the model.

woodseb

P. Breathnach wrote: »

I haven't studied it closely, but I understand that it was all based on a mathematical model that made risk disappear in a puff of smoke. Sometimes what is needed is a bit of hard-headed common sense, and that seemed not to have found its way into the model.

there are a lot of good books out at the moment on the topic. The Big Short by Michael Lewis is an informative and entertaining read on the crisis if you are looking for one

P. Breathnach

woodseb wrote: »

there are a lot of good books out at the moment on the topic. The Big Short by Michael Lewis is an informative and entertaining read on the crisis if you are looking for one

I'll keep an eye open for it, thanks, even though my reading schedule is a long way behind my acquisitions schedule.

Should it be put on the economics/finance shelf, or the history one, or with my too-small collection of fantasy?