Derivatives for the rest of us
What are Derivatives?
A derivative is essentially a binding contract for a person to buy or sell an asset at some point in the future, but the person is paying for it in the present.
Ah. This is a good start.
Derivatives are important in the world of finance because they allow for hedging and managing risk. They are one of the fastest growing segments in the financial market. However, since derivatives have no value themselves and are dependent on the value of another asset, there is a larger risk associated with them. While they can lead to quick profits, derivatives are best taken up by those who can understand the relationships between product volume, price trends and consumer interest.
So in other words, no one understands? Is this why derivatives are all computer generated? Did the creator of the program which derives derivatives know how they work? I highly doubt that.
"We view them as time bombs both for the parties that deal in them and the economic system .. In our view ... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."
- Warren Buffett, the Chairman of Berkshire Hathaway and his critique of the derivatives market. (March 2003)
"These increasingly complex financial instruments have especially contributed, particularly over the past couple of stressful years, to the development of a far more flexible, efficient and resilient financial system than existed just a quarter-century ago,"
- Alan Greenspan, Chairman of the Federal Reserve and his summary of the derivatives market (2002)
Derivative (finance) @ Wikipedia
Rather than trade or exchange the underlying asset itself, derivative traders enter into an agreement to exchange cash or assets over time based on the underlying asset.
Derivatives are often leveraged, such that a small movement in the underlying value can cause a large difference in the value of the derivative.
So from my reading Derivatives are leveraged risk via contract for profit. By themselves they have no value but represent a future scenario. The total "value" of the contracts is now $1.5 quadrillion.
These derivatives tie together banks and other institutions into one big mega corporation. That's the definition of too big to fail. Like dominos, push one over and they all go down. If one corporation that deals with derivatives fails, then the others which depend on them for their derivatives will also have to write down a loss (or maybe a profit for risking that they'd fail). Derivatives are so leveraged that a small failure could multiply and bring down one and thus them all. I don't buy Greenspan's idea that derivatives make the market more stable. Quite the opposite, they make the system less stable. This can be seen in the bank bailouts of 2008. Without the bailouts, we were told that nothing would survive and that martial law would follow.
Should derivatives be regulated? Absolutely. Should too big to fail not be allowed to continue? Absolutely. Even the FDIC is calling for action against the too big to fail situation. Could the system be put at risk again? Absolutely. Have we learn from our situation? Not in any way. Have we done anything to rectify the situation? Not in any way.