Perry Glasser

Derivatives Explained: Pay Heed or The Buccaneers Will Rob Us Blind!

In Economics, Finance, Politics, Wall Street on October 3, 2008 at 12:51 pm

Basics

An agreement between buyer and seller is the only way anything is assigned value. Nothing has intrinsic value.
Nothing.
Now suppose I want to buy your house. We agree on a price of $100,000 (cheap house!).
It does not matter that you bought it for $50,000 15 years ago; it does not matter that other houses on the street are selling for $125,000. The market value of your house is $100,000—an agreed upon price.
But I do not have $100,000. All I have is a reasonable expectation of being able to pay the price over time. For this privilege, I will pay annual interest to whomever lends me the money at a rate commensurate with the risk of my defaulting.
You could make me the loan, but for this example, assume you want the full amount in cash. You send me to the credit markets.
We are both a little nervous.. What if I can’t get a mortgage? What if while I am out shopping for credit, the market on houses changes so much that for one of us our agreed on price of $100,000 looks stupid?

The Derivative

So you give me 30 days to arrange the necessary credit. We enter a contract and I write a check for a manageable sum, say $5,000. We call it earnest money, meaning neither of us is screwing around. In a month, either the deal is closed or there is no deal.
We have a contract, meaning complementary considerations. In consideration for that earnest money, you agree to count my initial $5,000 toward the final purchase price. In addition, you agree not sell the house to someone else.
In consideration for your agreement to keep your house off the market for 30 days, I agree to forfeit the $5,000 if I change my mind about the whole deal or cannot arrange financing.
We shake hands.
Many Americans are familiar with the above scenario. Let’s look closely at that 30 days and that earnest money contract.

Mind Games

If there were a market in earnest money contracts, that contract might have value. Initially, it would be worth $5,000 — our agreed upon price—and we could say that its value rests upon an underlying asset, the value of the real property, the house itself.
Play a mind game…if the housing market soars on Day 15 of our agreement, and the house’s market value rises to $125,000, what is the value of my earnest money contract that specifies that you MUST sell the house for $100,000?
The value will be more than $5,000. If I could sell it to the Murgatroyd family (or back to you), I might ask for $8,000. I am not selling a house—I am selling the agreement on the house. The Murgatroyds will have 15 days to raise that $100,000, but if they succeed, they will be able to purchase a $125,000 house for $108,000—the agreed upon price of the house plus what they paid me for the buy option.
(Notice how we snuck that jargon in there?)
No…you don’t feel screwed.
Suppose instead the market value of the house had fallen by a like amount. After 30 days I begged off the deal, unwilling to spend -$100,000 on an asset now worth, say, $75,000. You’d have shrugged your shoulders, kept your house, and pocketed my $5,000 earnest money.
That’s right: you just made money buy NOT selling something.
Congratulations—you successfully hedged against losses. Instead of losing $25,000, you’ve lost only $20,000, and you still own the asset. With luck, it may rise in value soon.

Derivative Lessons

• The value of a derivative rests on the value of an underlying asset.
• Most derivatives have an expiration date—the deal is alive only so long.
• Derivatives cushion the effects of wide swings on prices of real underlying assets.
• If an asset can be bought and sold, a derivative market can be created.
• In fluid markets with rapidly changing asset prices, buyers and sellers make life more bearable and more predictable by dealing in derivatives. It’s called hedging.
• Derivatives are highly leveraged — look how for 30 days I controlled your $100,000 house for only $5,000! Why, for $50,000 I could control every house on your block!
• Oranges, coffee, wheat, silver, oil, gold, copper and other commodities are the underlying real assets of commodities futures.
• Shares of common stock are the underlying real assets of derivatives called puts and calls.
• The cost of money, what we call interest rates, is an underlying asset for a derivative called interest rate futures.

Enter the Buccaneers and Wizards

Dollar$ hastens to add that derivatives are a GOOD THING…until Buccaneers who with no care for eventual delivery of the underlying asset but lots of passion for wide price swings speculate in the derivatives market. When Wizards slacken the rules to accommodate Buccaneers, we are primed for looting and pillaging.
Wizards have changed the rules so there no longer needs to be an underlying asset. No house—just a contract. These so-called “naked” positions are especially prevalent in money markets. “Credit swaps” have been described by Warren Buffet as “financial weapons of mass destruction.” Smart guy, that Buffet.
Buccaneers setting sail with computerized, automated trading systems moving at the speed of light can take advantage of the tiniest swings in the market to make HUGE profits.
It’s that leverage. It is like catnip. Whoo-hoooo! With a $1 million, control $1 billion in assets! With $1 billion dollars, $10 billion… and at those levels, half of a percentage point, .005 of $10,000,000,000 is $50 million—not a bad day’s work!
Huge pools of leveraged funds in pursuit only of profit can make life hellish for those of us who buy gasoline, airline tickets, eat bread, or actually need money to purchase houses and cars.

Wanna regulate the Holy Open Market? Let the Weasels know you feel—send them a message they can’t ignore from your ballot box.

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  1. […] are blessed. See… with a credit swap you insure a borrower’s ability to pay off a loan. Derivatives are a hedge against wide price swings on a real underlying asset, right? But with credit swaps, we abandon the underlying asset, those uncreditworthy loans flooding […]

  2. […] security derivatives all day long, drive volume figures sky high, hedge those trades with even more arcane derivatives, and are able to place those transactions on exchanges all over the […]

  3. […] Buccaneer traders of the underlying commodity by rumor and financial maneuvering trade those highly leveraged future contracts. They have no intention of ever taking delivery. Famously, the Hunt brothers tried to corner the […]

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