Your Opinion On 'Derivatives'

[Terrafaux]

I'm curious to know what your opinion on derivatives is based on your understanding of what derivatives are. The term is bandied around quite loosely in the media, meaning there's much confusion about their technical applications and functions, scope, and nature, which is part of why I am asking this question.

Do you associate derivatives with the 2008 crisis? Smoke-filled rooms and Fed conspiracies? Do you reflexively react negatively at their mention? Are they a method to accumulate wealth riskily but quickly? Simply financial instruments of specified conditions which all private individuals involved can benefit from? Perhaps only a single party can benefit, thus representing some form of zero-sum approximation?

If you consider yourself well-versed in economics/finance, I'd appreciate you mentioning that in your post, especially.

Cheers

 

[celticwar17]

Only derivatives I am familiar with are the Mathematical ones... the equation of the slope. They and it's inverse, integrals, open up the door to all higher level Mathematics. I have a B.S. in Physics.

But I am sure that's not what your looking for xD.

 

[joG]

I'm curious to know what your opinion on derivatives is based on your understanding of what derivatives are. The term is bandied around quite loosely in the media, meaning there's much confusion about their technical applications and functions, scope, and nature, which is part of why I am asking this question.

Do you associate derivatives with the 2008 crisis? Smoke-filled rooms and Fed conspiracies? Do you reflexively react negatively at their mention? Are they a method to accumulate wealth riskily but quickly? Simply financial instruments of specified conditions which all private individuals involved can benefit from? Perhaps only a single party can benefit, thus representing some form of zero-sum approximation?

If you consider yourself well-versed in economics/finance, I'd appreciate you mentioning that in your post, especially.

Cheers

Derivatives are a very useful and highly potent instrument for managing and reallocating risk. Employed incorrectly you can do huge harm.

I have worked with derivatives as a user, designer, analyst and have advised on regulation and law.

 

[Manc Skipper]

The two Johns explained it most succinctly back in 2008. Chillingly, the quotes are true.

 

[KevinKohler]

A derivative is a contract between two people to exchange something, usually money (liquidity) at a specific date, based on the value of specific items.


For instance....I have a rare comic book worth 1,500 bucks. Another guy has another rare one worth the same, but it's not the same comic as mine. If we were to agree to exchange the VALUE of our comics, but not the comic itself, at a later date, that would be a derivative.

Were it all went haywire was people were making these derivative "bets" for "securities"...those toxic bundled mortgage loans...and THEN insuring those "bets" against losses.

I'm less upset with the bet itself, and more upset that an insurer would have been so foolish as to say, yeah, no problem, we'll cover you if you lose. And even THAT isn't completely upsetting...I mean, if someone wants to offer me a service, go for it. But as we all saw, the result as that we had this HUGE house of cards built atop ONE facet of our economy...home loans.

 

[whysoserious]

I will say I think all trading should be on the up & up. No dark room trades, no OTC, etc. All trades should be exchange sanctioned, regulated, and understood.

That being said, some derivatives have actual value. Options can be useful for hedging positions (covered calls). Futures can be useful for businesses to assure that 6 months down the line, they can sell their product at a respectable level.

Most derivatives are not used in the economy helping way I have listed above. They are mostly used as a way to leverage themselves or earn money risk-free.

 

[joG]

A derivative is a contract between two people to exchange something, usually money (liquidity) at a specific date, based on the value of specific items.


For instance....I have a rare comic book worth 1,500 bucks. Another guy has another rare one worth the same, but it's not the same comic as mine. If we were to agree to exchange the VALUE of our comics, but not the comic itself, at a later date, that would be a derivative.

Were it all went haywire was people were making these derivative "bets" for "securities"...those toxic bundled mortgage loans...and THEN insuring those "bets" against losses.

I'm less upset with the bet itself, and more upset that an insurer would have been so foolish as to say, yeah, no problem, we'll cover you if you lose. And even THAT isn't completely upsetting...I mean, if someone wants to offer me a service, go for it. But as we all saw, the result as that we had this HUGE house of cards built atop ONE facet of our economy...home loans.

Of course, it was more the housing loans than the derivatives that were the problem.

 

[whysoserious]

Of course, it was more the housing loans than the derivatives that were the problem.

How is that? How much money was lost via housing vs the securities?

I'd really like a number, but I can't find one myself. I feel like the answer would definitely be from the CDS and the mortgage-backed securities.

 

[iliveonramen]

I'm curious to know what your opinion on derivatives is based on your understanding of what derivatives are. The term is bandied around quite loosely in the media, meaning there's much confusion about their technical applications and functions, scope, and nature, which is part of why I am asking this question.

Do you associate derivatives with the 2008 crisis? Smoke-filled rooms and Fed conspiracies? Do you reflexively react negatively at their mention? Are they a method to accumulate wealth riskily but quickly? Simply financial instruments of specified conditions which all private individuals involved can benefit from? Perhaps only a single party can benefit, thus representing some form of zero-sum approximation?

If you consider yourself well-versed in economics/finance, I'd appreciate you mentioning that in your post, especially.

Cheers

I don't think there's anything inherently bad about derivatives.

It's like asking is debt bad. It depends and it's centered on what amount of risk you are willing to take on.

I think what can be dangerous about derivatives is that depending on the side of the contract you're on you can be assuming a lot more risk than you assumed and calculating that level of risk can be difficult to do.

 

[Terrafaux]

Thanks for the responses so far. I don't want to add much personal opinion here, but from my experience people who think derivatives are "evil" simply don't understand them, or associate all derivatives with fixed income securities derived from loans, or hazy geared derivatives, or so on. As already pointed out (most) derivatives are very simple and useful.

Buffett described derivatives as "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." But what he meant by this was not all derivatives, but certain classes of derivatives like collateralized debt obligations (CDOs, relatedly CMOs, CLOs, etc), sophisticated mortgage tranches, and so on i.e: instruments not very similar to the forward/swap/option paradigm of traditional derivatives.

 

[KevinKohler]

Of course, it was more the housing loans than the derivatives that were the problem.

Yes, but...the PROBLEM, is that we are stacking HUGE card houses onto ONE little thing...home loans.

 

[KevinKohler]

Thanks for the responses so far. I don't want to add much personal opinion here, but from my experience people who think derivatives are "evil" simply don't understand them, or associate all derivatives with fixed income securities derived from loans, or hazy geared derivatives, or so on. As already pointed out (most) derivatives are very simple and useful.

Buffett described derivatives as "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." But what he meant by this was not all derivatives, but certain classes of derivatives like collateralized debt obligations (CDOs, relatedly CMOs, CLOs, etc), sophisticated mortgage tranches, and so on i.e: instruments not very similar to the forward/swap/option paradigm of traditional derivatives.

The reason why they think this (I thought this) is due to a distinct lack of information being shared about them. We're lazy. We want this information not just available, but wrapped up in a nice, neat little, easy to understand package. And news media has failed to do so. It's hard to do, since this business world is constantly inventing it's own language.


I, like a poster above me, knows the word derivative from mathematics, and it means NOTHING at all what it means in finance. Who gave them a blank check to redefine MY language? Simple...they have done so in order to cement their usefulness. Without THEM, the layman can't understand what's going on, because the language is foreign. I think the same thing about lawyers.

 

[joG]

How is that? How much money was lost via housing vs the securities?

I'd really like a number, but I can't find one myself. I feel like the answer would definitely be from the CDS and the mortgage-backed securities.

The losses in securities derived from the losses in the loans underlying or backing the derivatives and securities. Those losses took down insurers and banks that caused losses beyond in a chain of events. It is not really a question of how much damage is attributable to loans, grantee contracts, derivatives, bonds etc. Major factors were poor regulation, sloppy supervision, lax money policy, government house ownership policy, intransparency and a number of other things.

As far as numbers are concerned, I will do a check, but do not promise to invest too much time unless you really need the numbers. They are not easy to find, you see.

 

[whysoserious]

The losses in securities derived from the losses in the loans underlying or backing the derivatives and securities. Those losses took down insurers and banks that caused losses beyond in a chain of events. It is not really a question of how much damage is attributable to loans, grantee contracts, derivatives, bonds etc. Major factors were poor regulation, sloppy supervision, lax money policy, government house ownership policy, intransparency and a number of other things.

The only thing I don't agree on is that you can always blame the catalyst. Yes, defaults on mortgages set the machine in motion, but the ridiculously leveraged mortgaged-backed securities and credit-default swaps were the Kraken that was released.

 

[Removable Mind]

Thanks for the responses so far. I don't want to add much personal opinion here, but from my experience people who think derivatives are "evil" simply don't understand them, or associate all derivatives with fixed income securities derived from loans, or hazy geared derivatives, or so on. As already pointed out (most) derivatives are very simple and useful.

Buffett described derivatives as "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." But what he meant by this was not all derivatives, but certain classes of derivatives like collateralized debt obligations (CDOs, relatedly CMOs, CLOs, etc), sophisticated mortgage tranches, and so on i.e: instruments not very similar to the forward/swap/option paradigm of traditional derivatives.

There's nothing simple about derivatives. Are you talking about them in relationship to "Futures", "Options", or "Swaps"?

Mortgage bundling, hedging, yadda, yadda, yadda...man, about 98.017432 percent of the people don't understand how any of these financial instruments/tranactions work. Hell, most people don't know about call and put options, arbitrage theories, leveraging, etc.

Why don't you begin with what your definition of "derivatives" is...or in what context they would be used for...in "layperson terms".

And don't dump value based "underlying assets, index, or securities" on everybody.

Give some real life examples of what your trying to get opinions on.

 

[joG]

Yes, but...the PROBLEM, is that we are stacking HUGE card houses onto ONE little thing...home loans.

I am not sure I would say that. While it is true that the sum of derivatives volumes cascade to a much larger number they cancel each other out.

 

[Terrafaux]

There's nothing simple about derivatives. Are you talking about them in relationship to "Futures", "Options", or "Swaps"?

Mortgage bundling, hedging, yadda, yadda, yadda...man, about 98.017432 percent of the people don't understand how any of these financial instruments/tranactions work. Hell, most people don't know about call and put options, arbitrage theories, leveraging, etc.

Why don't you begin with what your definition of "derivatives" is...or in what context they would be used for...in "layperson terms".

And don't dump value based "underlying assets, index, or securities" on everybody.

Give some real life examples of what your trying to get opinions on.

Conceptually ("meta-theoretically", maybe definitionally as a synonym too), derivatives are simple. I'm talking about the idea of derivatives in that post you quoted, not their implementation in practice. Complexity arises in the models which are used to simulate, estimate, quantify and evaluate derivatives, but the purpose, let's say, of derivatives should be simple to wrap one's head around, if that clears things up.

I don't want to define derivatives because the point of this thread is to see how most people define them and how that influences their opinions on derivatives; how structures like the media have an agenda in promoting certain views of them; etc.

I'm curious about the bolded, care to elaborate your thoughts?

Cheers

 

[ALiberalModerate]

Unregulated Credit Default Swaps are a disaster waiting to happen as the events of 2008 show.

 

[joG]

The only thing I don't agree on is that you can always blame the catalyst. Yes, defaults on mortgages set the machine in motion, but the ridiculously leveraged mortgaged-backed securities and credit-default swaps were the Kraken that was released.

Which leverage do you mean ie which construction do you have in mind?

 

[KevinKohler]

I am not sure I would say that. While it is true that the sum of derivatives volumes cascade to a much larger number they cancel each other out.

Too big to fail does not allow them to cancel each other out.

 

[OrphanSlug]

I'm curious to know what your opinion on derivatives is based on your understanding of what derivatives are. The term is bandied around quite loosely in the media, meaning there's much confusion about their technical applications and functions, scope, and nature, which is part of why I am asking this question.

Do you associate derivatives with the 2008 crisis? Smoke-filled rooms and Fed conspiracies? Do you reflexively react negatively at their mention? Are they a method to accumulate wealth riskily but quickly? Simply financial instruments of specified conditions which all private individuals involved can benefit from? Perhaps only a single party can benefit, thus representing some form of zero-sum approximation?

If you consider yourself well-versed in economics/finance, I'd appreciate you mentioning that in your post, especially.

Cheers

There is way too much confusion on derivatives, and ultimately it became a political catch phrase used by too many that do not understand the total scope of what they are.

A derivative is just a contract where the value is determined by an asset(s) or entity that has a entry value but subjected to market fluctuation ongoing. Futures contracts for commodities, forward contracts for just about any market asset, options contracts for the ability to buy a stock or asset at a later date but trade currently, credit contracts (CDS,) and asset or financial instrument swap contracts are all forms of derivatives.

They present an important speculation and hedge tool for market handling of just anything that does not have a fixed value. They get a bad name because of how *some* derivatives involve complex debt investment vehicles as the asset, and then hedged against future value of the asset in relation to the debt on the asset. The more complex the more often we get into insurance complications for the "bet."

Collateralized debt obligations originally had a strong market function to handle corporate debt and emerging market debt, it was once they moved into combinations of real estate debt, credit card debt and in some cases even student debt that things got very complicated. When it was a function of corporate debt these made good sense as they by effect normalized return on investment by collecting payments on the pool of debt in the CDO portfolio. The hedge was effectively grouping debt into structured payment for the investing party. Later when this became a function to move real estate debt onto investors to bet with it became problematic. Especially in terms of real estate debt from a prime and subprime point of view. Higher rates of return encouraged risky issuance of the new debt that eventually became collected up by the obligation portfolio. The higher the risk the higher the return, but the problem was the type of debt being issued. What that means is it was not the CDO itself that was the problem, or the mechanism it was designed to handle. Rather the problem was the type of debt being issued to secure higher rates of return and then grouped in mechanisms almost impossible to track or rate (risk and health.)

To answer your questions. CDOs did not cause the collapse, it was the source of debt within the CDOs that became problematic once real estate valuations stopped going up, defaults started happening more frequently for higher risk debt, and investment stopped buying into the bet. Real estate value going up was the hedge bet against a default, but if real estate goes down then the safety of the hedge disappears. Worse, asset accumulations often got so complex and quick as some CDOs included either parts of or entire other CDOs as a series of debt investments rolled up into one. Sometimes referred to as CDO "squared." Because a CDO is an asset, their evaluations day to day was complex. To answer another question of yours, they are also not zero sum games. In this type of derivative, they are mechanisms to merge investment capital with risk from a debt portfolio.

 

[joG]

Too big to fail does not allow them to cancel each other out.

I am not sure i see the allusion.

 

[whysoserious]

Which leverage do you mean ie which construction do you have in mind?

You can leverage positions via derivatives:

In general, leverage (or gearing) can be defined as borrowing funds to make investments. In the context of derivatives trading, investors can control large positions in derivatives for little amount of outlay or even for nothing at all.

In this case, you can leverage mortgage-backed securities by buying credit-default swaps. There is only one mortgage-backed security, since they represent a real thing: the securities contained within. However, you can buy as many CDS as the market will sell since it is a bet on the success of the MBS.

It's leveraging because you can buy into extremely large positions with a small amount of money (or no money).

 

[KevinKohler]

I am not sure i see the allusion.

Derivatives "cancel" each other out...meaning, SOMEONE wins, and SOMEONE loses.


If the loser is "too big to fail"....

 

[joG]

You can leverage positions via derivatives:


In this case, you can leverage mortgage-backed securities by buying credit-default swaps. There is only one mortgage-backed security, since they represent a real thing: the securities contained within. However, you can buy as many CDS as the market will sell since it is a bet on the success of the MBS.

It's leveraging because you can buy into extremely large positions with a small amount of money (or no money).

That is what I thought. Yes you can buy cds in the market. But the cds are produced and in the overwhelming majority of cases there are underlying securities those cds are based on.the original swap is hedged. So again yes you can purchase cds and pump up your position to extremes. But the total risk in the system will not do the same, though you have leveraged yourself enormously.