Friday, April 16, 2010

Derivatives Continued

FLG starts the day writing about how derivatives aren't that complicated or scary only to see that Chris Dierkes is hyperventilating over at LOG because of some jackass post by Graham Summer. FLG doesn't know what Graham Summer's personal money making angle in all this is, but he's got one. From a glance at his website, it looks like he'a probably a gold bug trying to scare the shit out of people to make them buy gold. In any case, his post is way off-base.

Chris posts this excerpt:
Let’s do some quick math.

If you add up the value of every stock on the planet, the entire market capitalization would be about $36 trillion. If you do the same process for bonds, you’d get a market capitalization of roughly $72 trillion.

The notional value of the derivative market is roughly $1+ QUADRILLION.

I realize that number sounds like something out of Looney tunes, so I’ll try to put it into perspective.

$1+ Quadrillion is roughly:

* 40 TIMES THE WORLD’S STOCK MARKET.
* 10 TIMES the value of EVERY STOCK AND EVERY BOND ON THE PLANET
* 23 TIMES WORLD GDP.

Please make note of the word notional. To use my illustration of the interest rate swap, if we swap payments from fixed and flexible rate payments on $100,000, then the notional amount of the swap is $100k. But that has almost no relevance to the amount of money changing hands in the swap or even the risk involved in the transaction.

Luckily, Chris updated his post twice with other links that weren't filled with hyperbolic and irrelevant claims, but still this is what worries FLG about the whole idea surrounding derivative regulation. Too many people have no fucking clue what they are, and react as many people do to stuff they don't understand -- with fear.

Again, they aren't that complicated in principle. The pricing mechanisms can be a bit complicated. And yes, even FLG, who is strongly pro-derivative, thinks they should be standardized on exchanges, but let's not get all fucking crazy.

4 comments:

Andrew Stevens said...

You should read this post. This will explain why you don't actually favor an exchange-trading requirement, but rather a clearing requirement.

I can't tell you how crazy it drove me during the whole crisis that people would refer to notional values as if they were a meaningful measure of the size of the derivative market. I'm glad to see I'm not the only one who was driven nuts by this.

Obviously I completely agree with you that none of this is very difficult to understand. But speaking as someone who has tried to explain them to some pretty smart people, I find that many people's eyes just glaze over when discussing financial instruments. A lot of people just seem to have some sort of mental block and only want to learn just enough to make whatever partisan political point they're interested in making, if that.

FLG said...

Andrew:

I totally conflated them, but my point was exactly what the post says about cleearing houses:
A clearinghouse provides critical counterparty risk mitigation by mutualizing the losses from a clearing member's failure, netting clearing members' trades out every day, and requiring that parties post collateral every day. Clearinghouses also centralize trade reporting, and can provide any level of post-trade transparency to the OTC derivatives markets that your heart desires — same-day trade reporting, including prices, aggregate and counterparty-level position data, etc.

Thanks for the link. I will be more careful in the future.

Andrew Stevens said...

Actually, I don't really care that much that you were making the conflation. The author of that blog seems to care a great deal though and I thought you might like to know his reasoning. If you read the article he linked to, he does have some strong reasoning, given the thinness of the trading on these derivatives, why a requirement of exchange-trading may be a bad idea.

Andrew Stevens said...

Actually, I don't really care that much that you were making the conflation. The author of that blog seems to care a great deal though and I thought you might like to know his reasoning. If you read the article he linked to, he does have some strong reasoning, given the thinness of the trading on these derivatives, why a requirement of exchange-trading may be a bad idea.

 
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