What's a derivative?

[tryan]

My math classes taught me one thing, but what is a financial derivative? And why are banks playing with these things? The risk seems more adaptable to the insurance industry ... but what do I know?

The derivatives market is now estimated at $700 trillion (notional, or face, value, not market value). The world's gross domestic product in 2009: $69.8 trillion; America's, $14.2 trillion. The total market cap of all major global stock markets? A mere $30 trillion. And the total amount of dollar bills in circulation, most of them abroad: $830 billion (not trillion).

DEBORCHGRAVE: Stock market time bomb? - Washington Times

 

[Gone4Good]

A financial derivative is simply something that "derives" its value from something else. It's typically a contract that references some other security, or index, as the basis for its value. A stock has an inherent value. Meanwhile a call option only has value in relation to the price of the stock on which it is written.

As to why banks are playing with these things, the simple answer is "because they can." But also because many are high margin products. As plain vanilla securities have become commoditized (bid offer spreads on stocks of a penny or less and trading commissions declining to pennies per share) there is pressure to come up with new products with less transparency and more pricing power. Enter "structured finance." The products themselves provide the opportunity to slice and dice risk in ways that you never could before. Theoretically this allows market participants to shed risk they don't want and only take the risk they feel they understand and handle. This was supposed to lead to greater dispersion of risk and a more stable financial system. In practice, though, derivatives mostly seem to have just allowed market participants to speculate on various kinds of scenarios and then leverage those bets for maximum reward (and risk).

 

[tryan]

Is it accurate to say "most" derivatives expire worthless with the facilatator collecting a fee for playing along. Looking at the size of the derivative market, it can't be a zero sum game.

 

[saluki9]

It would also be accurate to add that they like to throw out giant numbers like $700 trillion without mentioning that a very large percentage are offsetting transactions which then equate to zero exposure.

 

[saluki9]

Is it accurate to say "most" derivatives expire worthless with the facilatator collecting a fee for playing along. Looking at the size of the derivative market, it can't be a zero sum game.

Actually, it is a zero sum game for buyers and sellers. The money is made in origination and trading fees.

 

[brewer12345]

Is it accurate to say "most" derivatives expire worthless with the facilatator collecting a fee for playing along. Looking at the size of the derivative market, it can't be a zero sum game.

No idea if most expire worthless, but I bet that is not the case. Many derivatives are swaps in which case you might be swapping short interest rates for long ones and one of the two parties would make a payment to the other one every quarter.

The middleman does always get a fee/spread.

 

[tryan]

So the middleman plays the role of a "bookie" ... accepting bets which offset from 2 different parties. Collecting a fee for managing the game. If one bet is too large to cover with one other bettor ... then scramble to cover with lots of smaller bets. Perhaps even work the phones and peddle the opposing position.

Just legalized gambling (on everything from interest spreads to the weather)?

 

[saluki9]

Just legalized gambling (on everything from interest spreads to the weather)?

If it is your intent, almost every financial transaction can be compared to gambling.


Would you dollar cost average into an index fund if you weren't gambling on the share price going up?

I would also argue that if you're a farmer or a food manufacturer the using a derivative to hedge the weather isn't gambling. The same goes for a bank or insurance company that needs to offset some interest rate exposure.

 

[tryan]

I can't wrap my mind around the concept that there is a bettors market which is 10 fold the annual GDP of the United States.

How can 10x GDP exchange hands (if this is truly zero sum)?

 

[smjsl]

I can't wrap my mind around the concept that there is a bettors market which is 10 fold the annual GDP of the United States.

How can 10x GDP exchange hands (if this is truly zero sum)?

10x GDP does NOT change hands. Here is an explanation that helps from

The $600 Trillion Derivatives Market - Newsweek.com

A little background: derivatives are exactly what they sound like—their worth is derived from something else. That something else could be General Motors stock or Morgan Stanley bonds or any number of other items. In a credit default swap, for instance, a hedge fund that loaned $10 million to Southwest Airlines might agree to pay 1 percent a year, or $100,000, to an investment bank. In return, the investment bank agrees to pay the hedge fund the full $10 million if Southwest goes bankrupt. When journalists print big, scary numbers like the $668 trillion figure above, they're referring to the "notional value," or the worth of the underlying assets—$10 million in the Southwest example. In almost every case, only a small sliver of that ($100,000 in this case) is real money changing hands.

[...]

Saying there's $668 trillion in derivatives floating out there is like saying every lottery ticket sold is worth the full value of the jackpot. If the jackpot is $100 million and lottery organizers sell 2 million tickets, "that's $200 trillion worth of lottery wealth that's circulating!" jokes Figlewski. "When you say it that way, everybody knows that's a complete nonsense number."