Derivatives : LUSENET : TB2K spinoff uncensored : One Thread

A few recent threads have raised the spectre of 1929. Concern has been expressed over derivatives in the banking industry, though many people cannot define exactly what a "derivative" is.

Most folks understand that a stock is a "share" in an enterprise. The value of the stock is based on a fraction of the "value" of the company (in theory). Derivatives are instruments that derive their value from "something else." A simple example is the "option" to buy a stock at a given price. The stock option doesn't have an intrinsic value. Its value depends on the price of the stock (and other factors). Credit derivatives are common and serve a useful purpose in the financial services sector. In general, they help financial institutions manage various elements of risk. And like most tools, derivatives can be misapplied or mishandled... sometimes quite badly.

Derivatives create many of the same benefits (and headaches) as all financial instruments. When well managed, derivatives allow economic actors to minimize risk. Consider the benefit of the commodities futures market for farmers. There are also risks, including moral hazard when the Federal Reserve arranges for a bail-out of the LTCM.

I think derivatives offer an excellent example of the ever increasing complexity of our world... and how some individuals react to this complexity.

If you want to learn a bit more about derivatives, please see the following:

Federal Reserve article on credit derivatives.

A primer on derivatives

The "Intellishare" article is quite useful, particularly if you've never read much about the byzantine world of derivatives (or lost money playing options.)

-- Ken Decker (, May 08, 2000


Links are:

Link 1 and

Link 2.

-- (Sheeple@Greener.Pastures), May 08, 2000.


No flame intended, but what is your point?

-- J (Y2J@home.comm), May 08, 2000.

J -- I suspect that because there has been a lot of posting here recently about an upcoming economic collapse, and derivatives are one of the buzz words in that debate, Mr. Decker just wanted to inject a little actual information.

I, at least, found the post useful. There seems to be a common feeling that "derivatives" are some sort of arcane, doom causing investment that will bring down the entire economy. FUD.

-- E.H. Porter (Just, May 08, 2000.

Porter makes my point. I imagine there were people who predicted the downfall of mankind when the Medici's began lending money. We certainly have had a few people who think a fractional reserve system is the highway to Hell. A complex economy requires complex financial instruments. We have grown well beyond "cash on the barrel head." Derivatives are complex, but highly useful. We should not this broad family of financial instruments based on a few well publicized debacles... particularly when most of use benefit from them on a daily basis.

-- Ken Decker (, May 08, 2000.


I believe that Mr. Decker is missing the point about the fear over derivatives. As financial entities seek to reduce their risk exposure through the use of derivatives, the new risk that is inherently added to their situation is counter party risk. This is what is worrisome to those that understand derivatives.

For example, let's say that Farmer Jones enters into a futures contract with ABC elevator to sell his corn at $2.50/ bushel. Let's say that other farmers in the area enter into similar contracts. Now at harvest, corn has fallen to $1.75/ bushel. Farmer Jones, et al, are sure glad that they sold their corn at $2.50/ bushel, because some of them would fail this year if they only got $1.75/ bushel.

However, ABC elevator was run by an aggressive young man who was convinced that the internet was going to revolutionize the world, and he had invested heavily in internet stocks before the bottom fell out of that segment of the market. Because of his losses, ABC elevator was unable to perform on its end of the futures contracts with the farmers. As pointed out earlier, this caused a number of farmers in the area to fail, which in turn, caused 3 of the local banks in the area to fail, which caused a number of depositors at those banks to be unable to meet their financial obligations, etc.

Derivatives can indeed be complicated, but it is not too complicated to envision the kind of domino effect that could get started if a major player were to default on their end of their derivatives contracts.

Well, at least it wasn't too complicated for Alan Greenspan to envision about LTCM.

-- J (Y2J@home.comm), May 09, 2000.


It looks like we cross posted.

I agree that the term "derivative" is too often bandied about by those that are expecting a financial shakeout, even though those same people don't quite understand what a "derivative" is. If the point of your post was to help educate people about the world of derivatives, I think that you did a fine job by posting those links.

With the recent threads about impending financial collapse being fresh in the air, I couldn't help but conclude that you were not only trying to educate about derivatives, but also trying to persuade that they are not dangerous monsters once you understand them. I believe that argument is too simplistic, and that counter party risk is the key factor when assessing the risk that derivatives pose to the financial system.

If you were not trying to persuade, but only trying to educate, then please accept my apologies for creating a debate where none was intended.

-- J (Y2J@home.comm), May 09, 2000.

Bank Derivative Exposure Report (1998)

-- More (info@bout.derivatives), May 09, 2000.

Great report on derivatives, More.

Having spent twenty years teaching economics at the college level, and having written seven books on the subject, I feel I have a good understanding of the workings of derivatives in our financial system.

In 1990 the $6 Trillion in derivatives carried on the books of U.S. banks were thought to constitute a balloon. Now it's $35 Trillion. What, then, does that make the threat today?

BIGGEST DANGER is that these highly leveraged sums are so enormous that THERE ARE NOW NO BUYERS. It's the inherent ILLIQUIDITY of these instruments that has our collective head on the chopping block.

What has been happening has been this: each time a derivative package threatens to go sour, the banks-- not being able to unload, as investors in individual stocks and mutual funds do daily--instead HEDGE BY ACQUIRING STILL MORE DERIVATIVES. Thus the balloon has been inflated to such an enormous extent that it's true, explosive capacity can no longer even be estimated.

When the pin prick finally deflates this bubble, Heaven help us all. Run for cover, the exits, whatever safety you can find--for the debris, if it comes down on your head, will be instantly fatal.

-- Wellesley (, May 09, 2000.

We have grown well beyond "cash on the barrel head." Derivatives are complex, but highly useful.

Yeah, sort of like the "Hedge fund calculus" that almost single-handedly poleaxed the world banking system.

We should not this broad family of financial instruments based on a few well publicized debacles... particularly when most of use benefit from them on a daily basis.

The question is, What will the NET benefit be if you, like the wizards at LTCM, royally fuck up?

-- Wise Investor (@ .), May 10, 2000.

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