Part 1. Financial Derivatives and Defaut Swaps – Everything you ever wanted (or not) to know about them.

“Everything counts in Large Amounts…” – Depeche Mode.

So you want to understand the financial crisis more? Understand why we are all but in a depression (for we’ve been in a recession for at least a year, according to some analysts.) Then you have to understand the humble lil derivative.

Derivatives, what are derivatives, and what will explain to you what derivatives are? And why do they even matter?

Here’s a short synopsis of how I understand derivatives. Because I tend to verbosity, it will be a multi-part blog. Read it, and enjoy.

If you want to understand derivatives you may be tempted to picture financial voodoo; you make a circle in chicken blood, dance naked in it, wring the chicken’s neck, pray to a Loa, make the sign of the elder djinns over your forehead, and then you short sell derivative contracts on margin.

Some might say that you wouldn’t be too far from the truth.

Derivative instruments are at the center of the controversy about our Down Economy. The Bank of International Settlements [BIS] reports that the aggregate bank derivative positions to $516 trillion dollars in 2007, up from “only” $100 trillion dollars in 2002 – a 500 per cent increase in only five years.

Downright beastly.

Let’s stop talking about trillions, lets get real here – the not so good news is that the total trade in derivatives is somewhere around one quadrillion dollars.

Yes, a quadrillion.

“A quadrillion, how queer” you say. “I didn’t even know such a number existed”. For the record a quadrillion is 1,000 trillion dollars.

How is this number even possible? Through the magic of derivatives, that’s how.

Keep in mind the somewhat virtual nature of the modern economy.

You are imagining more money than the value of, well, the whole bloody world.

On the same token, and understand this point well, they do not appear on bank or corporate balance sheets

The total amount of derivatives floating around out there is than ten times the entire global GDP ($50 trillion), and more than seven times the world’s entire estimated real estate value ($75 trillions). Heck the entire US money supply is only $15 trillion dollars.

This is huge, understand the monstrous proportions involved here.

So what are derivatives, we are not talking about the type of derivative in Calculus, in finance derivatives refer to a type of financial instrument, originally used to manage risk to market players, but now used as a way of making obscene amounts of change to be properly spent on coke and call girls.

Picture for yourself a Contract.

Picture a contract that is bought and sold – traded – at an Exchange, by licensed brokers and traders. Basically whoever buys the contract buys its conditions.

Derivative contracts are used to lessen a player’s financial risks, while potentially offering large financial returns to another player, who in turn assumes a much greater risk in the transaction. This is called Hedging.

Hedgers may trade with other hedging producers/ owners of physical commodities or assets.

Hedgers may also trade with other speculators.

Speculators may trade with each other on an exchange floor.

Does any of this make sense? Well it soon will. Trust me, I lie to you not.

There are a few chief types of derivative contracts; futures, forwards, options, and swaps.

So I write a contract allowing you to buy 1,000 beanie babies for X amount on Sept 1 2009.

There you go, that is a FUTURE contract, it is a derivative in a sense since its based on the value of a cargo of 1,000 beanie babies. Truth to tell, this example sucks, but it gives us starting room.

So Shannon writes Lisa a contract giving her the option of buying Lisa’s bankrupt coffee shop chain, in 90 days, at $1,000. Shannon can exercise that option in 90 days, fork over $1,000, or she can choose not to. Behold dear reader, this is an OPTION contract.

As for forwards, they are similar to futures. And Swaps are weird, so I’ll go into them later.

A derivative’s value, and hence it’s name, come from the fact that it is DERIVED from the value of something else. A derivative is like a coat, sitting on a mannequin in a store, it takes its approximate shape from the shape of the body wearing it. Two players agree to financial remuneration, according to the value of a certain type of asset or information, at a certain discrete point of time. The derivative’s value is thus derived from the underlying asset.

What kind of asset? Anything, or at least anything legal. Or even illegal, I’ve heard some guys in California setup a Marijuana commodity exchange. Kid you not.

Commonly used assets used to back a derivative include securities of all types, stock equities and bonds, commodities, currency exchange rates, interest rates, but they can also include an index. Or a group of indices–a set of specific indexes, such as the Consumer Price Index, or you can even use an index of weather conditions.

Re-read that statement. The asset or information can literally be anything of value, value to someone.

The performance of the asset determines both the amount of financial payoff and its timing.

As a price hedge, a derivative instrument transfers risk by enabling an investor to take a position in a transaction of equal value but in direct opposition to another investor.

For example, in a futures contract a producer will buy or sell a futures contract to purchase or sell production, for example a crop of cotton, or a certain numbers of barrels of oil, to or from a speculative investor BEFORE the actual production of the commodity,

The Producer or Owner of the commodity is, here, a “Hedger” seeking to hedge his or her risks. The investor is a speculator.

Example 1: on July 20 2007 Io the farmer sells 10,000 bushels of organic wheat to Yif the investor, for future delivery on March 1 2008 at a certain set price per bushel. She sells well before the actual wheat harvest.

Example 2: On October 3 2007 Exxon/Mobile sells to Anita a contract to purchase 30,000 bbls (barrels) of North Sea Crude Oil, for future delivery on July 1 2008 “CIF” (Cost Freight and Insurance pre-paid) to Port of Rotterdam, Netherlands, at a certain set price per barrel. Anita, ever the a bright eyed speculative investor, wants to buy before the actual production of that Crude Oil.

By taking a position in the futures market, either “I intend to sell this oil / I intend to buy this oil” the producer / owner of the commodity (Farmer Io, or Exxon Mobile) minimizes her financial risk, due to price fluctuations.

Price fluctuations are due to anything. Risk is defined as uncertainty.

What causes uncertainty? War, Drought, Floods, Hurricanes, race riots, assassinations, adverse actions from your competitors, plagues, raining of blood from the heavens, massive deaths of first born sons, or any number of seemingly baleful acts of God or Man that may or may not afflict the producer.

“Seemingly baleful” – one man’s poison is another man’s sugar.

Price Fluctuations may cause loss to the producer / seller, and cause massive gain to the buying investor, or vice versa.

Theirs is spiffy magic in this, if you understand it – the magic, if you will, is that the asset need not be physical, it could be completely speculative. If I publish an index of Beanie Baby prices someone, somewhere, could legitimately create a derivative instrument based on it and trade it.

1 Comment

  1. wtf ?

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