The Money Matrix - What the Heck Are Derivatives? (PART 10/15)
This article seeks to define financial derivatives and why they are so important. Future and spot market basics are also examined so the Reader understands how the price of gold and silver is determined. by Jake Towne, the Champion of the Constitution
(libertarian)
Tuesday, December 9, 2008
First, why should we care?
"Derivatives are financial weapons of mass destruction." Warren Buffet, 2003
Good enough. Reader, the term "derivatives" have been bandied about and even demonized by many writers (including myself), so it's best to understand them and their importance. This article will first define derivative, fully answer the above question, and in the third section give a quick lesson on some future and spot market basic terms.
Modern financial derivatives all started with commodities, namely rice and grain. The earliest recorded financial derivative market I know of came in the early 1700s in imperial Japan at the Dojima Rice Exchange. Although the realm did use coins, they also used rice as another major form of indirect exchange. (Part 3 explained why using rice was a horrible idea.) The samurai stole (or to be more polite, taxed) rice from their serfs, but due to a set of bad harvests and market manipulations by traders, they found their purchasing power to be very adversely effected. A funny way to think of it is that new armor & swords, and lovely geishas were too expensive in terms of rice. Our poor samurai were left scratching their helmets on what to do. (photo)
The samurai decided to sell their harvests forward to stabilize their income. For instance, Joe the Samurai convinces Bob the Trader to give him a set amount of coinage (say 15 coins, or the futures price) in exchange for his rice crop (say 1 bushel) that will be delivered on a settlement day (say 3 months later). When this "futures contract" settlement date arrives, Joe gets the 15 coins, Bob gets the bushel of rice and sells it, hopefully for the price he was expecting to receive, say 18 coins. Joe gets the steady income he desired. Bob makes a tidy profit of 3 coins in return for risking that the price of rice would drop below the spot price on the date he sells the bushel. In other words, Joe the Samurai trades his price risk (the rice's price volatility) for Bob the Trader's basis risk (the difference between the futures price and the spot price). Spot price is the market price for immediate delivery on the day Joe and Bob made the contract).
This process of transferring risk from those without capital to those that do for the possible economic gain of each can enable overall economic growth. However, let's say there is a glut of rice, depressing the price on the settlement date. Joe the Samurai is still happy; he still gets his expected income. However, Bob the Trader will take a loss. Bob the Trader also has the possibility that rice will be scarcer than expected, leading to higher profits for him. Likewise, if Joe does not produce the rice, he has no income, and perhaps also needs to pay Bob the Trader his expected basis risk to compensate for tying up his capital.
Simplified, the term "derivative" refers to a "derived" wager, or bet, on the price of something, in this case rice, at some point in the future. However, I will add this was not an idyllic process for the Japanese; it was full of starvation, riots, monopoly traders, and messy government intervention. Severe economic inefficiency where a select few profit, sound familiar?
However, I want to point out that derivatives are by no means "evil" in this respect, no matter how much disgruntled modern-day traders and economists demonize them. It is also important to recognize that these primitive "derivatives" always consisted of wagering on something with intrinsic value, like a commodity.
Now a formal definition:
Derivatives - financial contracts or instruments, whose values are derived from the value of something else, which is termed the "underlying." The main types of derivatives are futures, forwards, options and swaps.
The main use of derivatives is to reduce risk for one party. The diverse range of potential underlying assets and pay-off alternatives leads to a wide range of derivatives contracts available to be traded in the market. Derivatives can be based on different types of assets such as commodities, equities (stocks), residential mortgages, commercial real estate loans, bonds, interest rates, exchange rates, or indices (such as a stock market index, consumer price index (CPI) or even an index of weather conditions).
Credit derivatives have become an increasingly large part of the derivative market. These are financial contracts that explicitly shift credit risk from one party to another. Instruments include over-the-counter (OTC) credit derivatives, such as credit default swaps, total return swaps, and credit spread options.
Credit default swaps are probably the most infamous credit derivative. These enable lenders to a company to purchase what amounts to insurance that will protect them if the company defaults on its debts.
There are two kinds of derivatives
Over-the-counter (OTC, or direct buyer-to-seller) derivativesare contracts that are traded and privately negotiated between two parties. All OTC derivatives are unregulated, so the counterparty risk is the key factor: basically, when the contract terminates will one party stay solvent and reimburse the other without going bankrupt? According to the BIS, the total outstanding notional amount is $684 trillion as of June 2008. Of this total notional amount, 67% are interest rate contracts, 8% are credit default swaps (CDS), 9% are foreign currency exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 13% are other assorted types.
Exchange-traded derivatives (ETD) are those derivatives products that are traded on regulated exchanges or markets. The exchange acts as a public intermediary for all transactions, and takes on the counterparty risk for a fee. As such, the exchanges pay close attention to all party's solvency, so party defaults are less likely than on OTC derivatives. According to the BIS (pg 108/116), the total outstanding notional amount is $77 trillion (as of June 2008.)
And now the reason for Buffet's concern becomes clear. As the world's reserve currency, the majority of all derivatives are transacted in dollars. And these trillions of dollars of worthless fiat electrons truly dwarf the rest of the world. I can show you and I bet I do not even need a graph!!
~8 Trillion Total Monetary Supply of US Dollars, cash, coin, and banking accounts <$100K (Federal Reserve M2)
15 Trillion Total US 2008 GDP, or the market value of all goods and services by all American parties
50 Trillion Total world GDP in 2008 per US Global
75 Trillion Total value of the world's Real Estate per US Global
77 Trillion Total nominal value of world's ETD derivatives per BIS
100 Trillion Total value of the world's stock AND bond markets per US Global
684 Trillion Total nominal value of world's OTC derivatives per BIS
So the key is that due to their massive size and inherent risk, derivatives (primarily OTC), have the potential to deliver truly staggering losses that could ripple through the rest of the financial system like a bullet train with no brakes down the slope of Mount Everest.
I think the basic trouble behind modern-day derivatives can be summed up rather succinctly. Many of today's derivatives are wagering on paper "assets" that have no intrinsic value. To wager on freely traded tangibles like corn or wheat on a commodities exchange with counterparty risk protection is one thing. To wager on paper "assets" like interest rates of a GE bond, a Fannie Mae mortgage, or the fiat Australian dollar without counterparty protection from fraudulent balance sheets, themselves consisting of fiat electrons, is pure madness.
Why and how did the mess get this big? Super briefly, Alan Greenspan of the FED decided to not regulate OTC derivatives 10 years ago. Following this decision, they mushroomed. My personal root cause analysis is that many of the traders doing the deals have no idea what makes money money, nor did they 100% understand what they were transacting, and were lured by the "miracle" of leverage and the siren song of "risk-free" profits, a complete misnomer.
Spot priceis the market price of a commodity for immediate delivery. Cash is slapped on the barrel and the goods forked over right away.
Futures contracts buy or sell a standardized quantity of a specified commodity of standardized quality (which, in many cases, may be such non-traditional "commodities" as foreign currencies, commercial or government bond, or "baskets" of corporate equity) at a certain date in the future, at a price (the futures price) determined by the instantaneous equilibrium between the forces of supply and demand among competing buy and sell orders on the exchange at time of purchase or sale. Fancy talk for the futures price fluctuates all the time via a bid-ask system and includes storage and finance fees.
Contango occurs when the futures price is greater than spot price. Physical commodities (such as gold and silver) typically have a higher futures price since the holder is responsible for carrying costs.
Backwardation occurs when the futures price is less than spot price. For physical commodities (such as gold and silver) this situation is typically remedied since parties holding the commodity sell it for spot and then repurchases the "paper" commodity back at the cheaper futures price.
Basis is the difference between the futures price and the spot price. When futures are in backwardation, they are said to have a "negative" basis, while in contango a "positive" basis.
Long position is the party who agrees to receive a commodity.
Short position is the party who agrees to deliver a commodity
Time has changed, what's going wrong? We can only regress as time marches on! Down with the system! Enough of the lies! You can only realize if you open up your eyes!I don't know if we're ever gonna see, tell me what's gone wrong with society!Got no future, this is no life for me! And I don't know just what went wrong, all that I know it's gone on too long!... Look ahead, what is our fate? To make the same mistakes we made yesterday or do we try to save ourselves? Or sit back and laugh as it all goes to hell?
- Pennywise, "Time Marches On" from their Land of the Free? album
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The views expressed
in this article are those of Jake Towne, the Champion of the Constitution only and
do not represent the views of Nolan Chart, LLC or its affiliates.
Jake Towne, the Champion of the Constitution is solely responsible for the contents
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with Nolan Chart, LLC in his/her role as a columnist.
Good one, Jake. You hit the nail on the head. Derivatives were originally "derived" from commodities that had intrinsic value, grain, metals, etc. Could it be that these new "derivatives" are worth only the heat that can be generated by burning the paper they're written on?
Terriffic article Jake. The clouds of mystery surrounding derivitives have parted for me. In addition, I now understand the nervousness suffered by conservative investors over derivitives.
The lack of regulation of OTC derivitives is truly madness. Alan Greenspan's decision to not regulate OTC derivatives is another collossal flummax by the man who caused the banking & mortgage bubble by drasticly lowering interest rates & encouraging subprime loans. In my humble opinion, Mr. Greenspan has done more financial damage to this country than Al Queda has. And when this financial fiasco completely plays out, the number of lives it will have destroyed may exceed Al Queda's tally also.
Posted By: Michael Sobol
Date: 2009-01-31 07:12:42
Everyone talks about the subprime as the cause-it is apart of the problem. The betting with NO regulators,Senator Phil Gramm's Commodities Futures Modernization Act set the stage for the party. You can't leave the kid in the candy store without supervision. Until we acknowledge that, reinstate Glas-Stegal, we will never get to the bottom of this mess.The system is bankrupt. Go into bankruptcy, set up a National Bank, take over the Fed and set up a credit currency, backed by a fixed rate exchange and let's move forward. Otherwise we are in for years of despair.
Modern financial derivatives all started with commodities, namely rice and grain. The earliest recorded financial derivative market I know of came in the early 1700s in imperial Japan at the Dojima Rice Exchange. Although the realm did use coins, they also used rice as another major form of indirect exchange. (