Derivative Markets Explained To The Layman

[roadwarrior]

This explains everything.

Subject: Derivative Markets explained for the layman.

An Easily Understandable Explanation of Derivative Markets:

Heidi is the proprietor of a bar in Detroit. She realizes that virtually all of her customers are unemployed alcoholics and, as such, can no longer afford to patronize her bar. To solve this problem, she comes up with new marketing plan that allows her customers to drink now, but pay later.

She keeps track of the drinks consumed on a ledger (thereby granting the customers loans).

Word gets around about Heidi's "drink now, pay later" marketing strategy and, as a result, increasing numbers of customers flood into Heidi's bar. Soon she has the largest sales volume for any bar in Detroit.

By providing her customers' freedom from immediate payment demands, Heidi gets no resistance when, at regular intervals, she substantially increases her prices for wine and beer, the most consumed beverages. Consequently, Heidi's gross sales volume increases massively.

A young and dynamic vice-president at the local bank recognizes that these customer debts constitute valuable future assets and increases Heidi's borrowing limit. He sees no reason for any undue concern, since he has the debts of the unemployed alcoholics as collateral.

At the bank's corporate headquarters, expert traders transform these customer loans into DRINKBONDS, ALKIBONDS and PUKEBONDS. These securities are then bundled and traded on international security markets. Naive investors don't really understand that the securities being sold to them as AAA secured bonds are really the debts of unemployed alcoholics.

Nevertheless, the bond prices continuously climb, and the securities soon become the hottest-selling items for some of the nation's leading brokerage houses.

One day, even though the bond prices are still climbing, a risk manager at the original local bank decides that the time has come to demand payment on the debts incurred by the drinkers at Heidi's bar. He so informs Heidi.

Heidi then demands payment from her alcoholic patrons, but being unemployed alcoholics they cannot pay back their drinking debts. Since, Heidi cannot fulfill her loan obligations she is forced into bankruptcy. The bar closes and the eleven employees lose their jobs.

Overnight, DRINKBONDS, ALKIBONDS and PUKEBONDS drop in price by 90%. The collapsed bond asset value destroys the banks liquidity and prevents it from issuing new loans, thus freezing credit and economic activity in the community.

The suppliers of Heidi's bar had granted her generous payment extensions and had invested their firms' pension funds in the various BOND securities. They find they are now faced with having to write off her bad debt and with losing over 90% of the presumed value of the bonds. Her wine supplier also claims bankruptcy, closing the doors on a family business that had endured for three generations, her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 150 workers.

Fortunately though, the bank, the brokerage houses and their respective executives are saved and bailed out by a multi-billion dollar no-strings attached cash infusion from the Government. The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-drinkers.

Now, do you understand?

[senile1]

Great explanation, Kent! I already understood derivatives. What I don't understand is why they aren't regulated more and why it isn't a crime, in some cases, to do this. To me, what happened with the Derivatives market relating to the housing debacle is fraud and should be punishable by prison sentences. The news media seems to think that some of the organizations selling these didn't know what the possible results could be. I beg to differ. I took only 15 hours of accounting in college and I knew better. Give me a break. These people sold fraudulent securities, walked away with a rich commission, and faced no risk in the process. All of the risk burden belonged to the economy and the working men and women. That's not free enterprise. In free enterprise you take the risk and if it pans out you reap the rewards. These people reaped the rewards with no risk. Did they know that many of the home buyers wouldn't be able to pay the bills to ultimately back the mortgage derivatives? I think that anyone with a basic understanding of accounting should have seen the writing on the wall.

Sorry for getting on the soapbox. This subject makes me mad as hell.

[Root beer]

Great explanation, Kent! I already understood derivatives. What I don't understand is why they aren't regulated more and why it isn't a crime, in some cases, to do this. To me, what happened with the Derivatives market relating to the housing debacle is fraud and should be punishable by prison sentences. The news media seems to think that some of the organizations selling these didn't know what the possible results could be. I beg to differ. I took only 15 hours of accounting in college and I knew better. Give me a break. These people sold fraudulent securities, walked away with a rich commission, and faced no risk in the process. All of the risk burden belonged to the economy and the working men and women. That's not free enterprise. In free enterprise you take the risk and if it pans out you reap the rewards. These people reaped the rewards with no risk. Did they know that many of the home buyers wouldn't be able to pay the bills to ultimately back the mortgage derivatives? I think that anyone with a basic understanding of accounting should have seen the writing on the wall.

Sorry for getting on the soapbox. This subject makes me mad as hell.

interest rate...Federal Reserve should have stepped in and raise the rate. Loans should have been slowed down.

Oh well. It probably going happen again since I read the news that two democratic law makers are asking Fannie Mae and Freddic Mac to loosen up the RECENT loan standards. The lawmakers thinks the new standards will shunt growth. :

[moby bass]

Excellent explanation, thank you.  The real crime here, IMO, is the bailout with non drinking taxpayer money.  Everyone else got what they deserved by perpetuating all the unsecured debt. Any one of them could have stopped at any time, or better yet, not even started with the unsecured loans, but greed got in the way.  Caveat Emptor.

[tyrius.]

That isn't an explanation of Derivatives. It's an explanation of a type of Asset Backed Security.

The financial instruments described in your post are actual debt being traded and not a trade based upon an event. A derivative that would apply would be that AIG sold "insurance" to the purchasers of the PUKEBONDS in the case that the bar patrons who make up the PUKEBONDS default on their debt. This is a credit default swap, the purchaser of the PUKEBOND swaps the risk of default to the "insurer" (AIG) for a given sum of money.

edited for a grammar mistake

[South FLA]

For somewhat better definitions go here:

http://www.investopedia.com/

tyrius is correct by the way.

[Root beer]

Derivative.

A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.  

How does that not relate to what RW posting? Asset Back security is type of bonds they are, Derivative is the math equations they used.

I assume the bonds RW post is being calculated, valued, etc by derivative (which I'm looking forward to this fall in calculus class)

Derivative while Asset Backed security is the underlying asset....

[tyrius.]

How does that not relate to what RW posting? Asset Back security is type of bonds they are, Derivative is the math equations they used.

I assume the bonds RW post is being calculated, valued, etc by derivative (which I'm looking forward to this fall in calculus class)

Derivative while Asset Backed security is the underlying asset....

A Math derivative is not the same as a Finance derivative.

[roadwarrior]

Just for fun guys, it's intended to be "simple".

8-)

[tyrius.]

Just for fun guys, it's intended to be "simple".

8-)

I agree, that's why I didn't respond about any of the specifics.  I wanted to make sure that people had the correct term though.

[natanestaban]

I WISH YOU COULD HAVE BEEN ONE OF MY COLLEGE PROFS.

BAMA NATE

[fivesixone]

I WISH YOU COULD HAVE BEEN ONE OF MY COLLEGE PROFS.

BAMA NATE

For real... Thanks for droppin' some knowledge!

[Glenn]

Good explanation, and provides a good understanding of a small sliver of the big picture.

[Root beer]

So Tyrius, in finance, derivative sort of work like this..I buy a bond and I then purchased insurance on it in event it defaults. If the bond defaults I collect insurance money from whoever sells me the insurance policy? If the bond doesn't default I collect the interest from the bond, but I lose money on the premium I had to pay in order to get the insurance policy?

While in math derivative is some form of mathematical equations use to calculate rate of change? Which I will learn this fall.

I hate it when same word means two different things to other people.

[tyrius.]

So Tyrius, in finance, derivative sort of work like this..I buy a bond and I then purchased insurance on it in event it defaults. If the bond defaults I collect insurance money from whoever sells me the insurance policy? If the bond doesn't default I collect the interest from the bond, but I lose money on the premium I had to pay in order to get the insurance policy?

While in math derivative is some form of mathematical equations use to calculate rate of change? Which I will learn this fall.

I hate it when same word means two different things to other people.

The credit default swap is only one type of derivative, but that is one example.  It isn't called insurance, but that is in essence what it is.  I contract with another party to pay me a sum of money in the event that a certain party (bondholder) defaults.  Derivative transactions are based upon events.  Whereas the intial example is based upon an actual security (a loan).  

Calculus derivatives make zero sense to me.  I suck at calculus.

[Root beer]

The credit default swap is only one type of derivative, but that is one example. It isn't called insurance, but that is in essence what it is. I contract with another party to pay me a sum of money in the event that a certain party (bondholder) defaults. Derivative transactions are based upon events. Whereas the intial example is based upon an actual security (a loan).

Calculus derivatives make zero sense to me. I suck at calculus.

Gotcha! I understand now. When I first read the derivative definition it sounds like it was some form of equations on an underlying assets (ex: bonds, stocks, etc) so I was thinking it was something else. When you brought up credit swaps and stuff it made it sound like some form of portfolio insurance rather than a form of derivative.(I guess portfolio insurance and derivative would fit in same category right?) It weird how some books worded the definitions.

The definition of derivative from investopedia.com had words like fluctuation and underlying asset in same sentence. To me it sound like it was some equation calculating prices, values, etc on the underlying assets. It just sounded like some investment vehicle with weird math model on the underlying asset.. Oh well, I got it now, thanks.

P.S. Is this what causes AIG demise? They entered into a one too many derivative on mortgage backed security?

[RoLo]

Good read RW, I like that analogy

You got Heidi's number?

So Tyrius, in finance, derivative sort of work like this..I buy a bond and I then purchased insurance on it in event it defaults. If the bond defaults I collect insurance money from whoever sells me the insurance policy? If the bond doesn't default I collect the interest from the bond, but I lose money on the premium I had to pay in order to get the insurance policy?

While in math derivative is some form of mathematical equations use to calculate rate of change? Which I will learn this fall.

What you described is a "hedge", which is actually a strategy rather than a derivative,

but indeed hedges typically employ derivatives.

I hate it when same word means two different things to other people.

"Derive" is the root-word and has only one meaning, but the derivative per se will vary according to the application.

For instance, "aluminum" is a derivative of bauxite, while "options" are a derivative of stocks.

To keep it simple, most of us started out with a weekly allowance from our parents (mine was 50-cents per week).

This provided me with enough "spot cash" to buy a few packs of baseball cards and a couple of fudgsicles.

When the spot cash was gone, my buying stopped. As we grow older we realize that if we so choose,

we can continue to spend even after the spot cash is gone.

The only way to generate capital leverage is to use OPM (other people's money), but leverage is a double-edged sword.

Buying or selling a derivative is little different than placing a bet. With a derivative, you're not holding secure equity,

but have a contract that wastes away with time.

Roger

[Zel]

Since there seems to be some disagreement about financial terms, below is a list of several business and finance terms explained so that anyone can understand them. While they are meant to be humorous, there's also a lot of truth in many of them.

Advertisement: A tool used by business to get money out of people that don't have it, for something that they don't need.

Alimony: Two person mistake paid by one.

Auditor: Person that arrives after battle to finish off the wounded.

Bank: A place that will lend you money only when you don't need it.

Bear Market: Eight months when the kids get no allowance, the wife gets no jewelry and the husband gets no you-know-what.

Broker: The person that you trust with thousands of your hard earned dollars. Hello!

Budget: Written proof that you can't afford the things you want.

Bull Market: A random market movement causing an investor to mistake himself for a financial genius.

Cash Flow: The movement your money makes as it disappears down the toilet.

CEO: Chief embezzlement officer.

CFO: Chief fraud officer.

Day Trader: A more socially acceptable gambling addict.

Discounted Stock: A stock that is less expensive than last month and more expensive than it will be next month.

EBIT: Earnings before irregularities and tampering.

EBITDA: Earnings before I tricked the dumb auditor.

EPS: Eventual prison sentence.

FRS: Fantasy reporting standards.

Institutional Investor: Past year investor who is now locked up in a mental institute.

Market Correction: The day after you buy stocks.

Momentum Investing: the fine art of buying high and selling low.

P/E Ratio: The percentage of investors wetting their pants as the market keeps crashing.

Profit: A man that prays to God.

Standard and Poor (S&P): Your life in a nutshell.

Stock Analyst: Idiot who just downgraded your stock.

Stock Market Correction: The term your broker uses for a stock market crash.

Stock Split: When your former wife and her lawyer split all your assets equally between themselves.

Value Investing: The art of buying low and selling lower.

[Root beer]

Zel, while I've heard of some those terms, but rest I haven't. Still too funny. ;D

[tyrius.]

The definition of derivative from investopedia.com had words like fluctuation and underlying asset in same sentence. To me it sound like it was some equation calculating prices, values, etc on the underlying assets. It just sounded like some investment vehicle with weird math model on the underlying asset.. Oh well, I got it now, thanks.

That's a different type of derivative.  As I said earlier there are multiple types.  A call option on a stock is an option to buy a stock at a given price within a given timeframe.  If you buy a call option for company X at $10 and their stock price rises to $15 then you get to buy the stock at $10 and turn around and sell it at $15 for an immediate profit.  If the price doesn't increase then you dont' excercise your option and you lose whatever the option cost you.  A put option is the reverse of the call option.  

So the fluctuation in the price of the asset (stock of company X) determines the value of the option.

There are still many other types of derivatives.

[Root beer]

I know what options are, I've participated in option trading already. I did a buy-write option on Ford Motor company and profit from it. I kept the strike price above what I paid for the stocks, so even if it he exercised it I still made a profit. He later exercised it, so I made premium profit plus the stock themselves.

You know any links that has a list of derivative strategy, or do I have go to investopedia.com and just compiled my own set of list?

[Maxximus Redneckus]

Just for fun guys, it's intended to be "simple".

8-)

ya its not for you smart alecks its for people like me.. i understood it completely  8-)

[Pond Hopper]

One  thing that gets me(being in the Ag industry) is that my buddy that I help farm, uses a price guarantee(insurance) to allow him to sell grain out of his bin, at current price on a given date, but the guarantee is for a certain dollar amount.  Should grain go up he is given the difference between the increase and the cost of the guarantee.  I then go and buy puts(on the same delivery date and grain) to protect any downswings in the price, and when the grain is delivered it always seems that the price has moved enough to cover both the cost of the guarantee, the puts, and some added profit.  I know how it all works but still have problems figuring out where the losing side is.  

I guess it is all part of the gamble.  

[RoLo]

One thing that gets me(being in the Ag industry) is that my buddy that I help farm, uses a price guarantee(insurance) to allow him to sell grain out of his bin, at current price on a given date, but the guarantee is for a certain dollar amount. Should grain go up he is given the difference between the increase and the cost of the guarantee. I then go and buy puts(on the same delivery date and grain) to protect any downswings in the price, and when the grain is delivered it always seems that the price has moved enough to cover both the cost of the guarantee, the puts, and some added profit. I know how it all works but still have problems figuring out where the losing side is.

I guess it is all part of the gamble.

The problem with options (Puts or Calls) is a little thing called "Time Value".

Even if the price falls while you're holding an outright Put, it may still expire worthless.

The price must "decline", it must also decline "soon", and it must also decline "significantly"

If any one of those three are missing, you stand to lose money on the Put.

To be profitable, the Put must be deep enough "in-the-money" (beyond the strike)

to override Time Value erosion, Slippage and specialist Arbitrage.

Roger

[South FLA]

For those of you who like options read this:

http://www.streetauthority.com/terms/options/1.asp