Friday, April 16, 2010

Derivatives

From a Brookings Institution paper FLG intends to read:
After all, derivatives are difficult for non-experts to understand and seem unrelated to every day things most people really care about in times like these – such as their jobs and how they will be able to pay for their children’s education or their own retirement.

This is the thing about derivatives that most shocks FLG. The concept isn't all that difficult to explain. A couple of paragraphs down, the author mentions some types of derivatives:
Derivatives such as futures and options contracts, and various kinds of “swap” arrangements (involving interest rates, foreign currencies, and loan defaults), provide efficient ways for both financial and non-financial users to hedge against a variety of financial risks.

FLG thinks he can define all these very simply.

Future contracts -- An agreement today to buy/sell something at some specified date in the future at a specified price. That something could be things as diverse as pork bellies or currencies, but the concept isn't difficult. Today, FLG agrees to sell you 100,000 euros for $120,000 90 days hence and you agree to complete the transaction.

Option -- Same thing as a future, but you have the option not to complete the deal.

Swaps -- Literally swapping something. Interest rate swaps are probably the easiest to explain. If FLG has a $100,000 fixed rate loan that somebody is paying back to him and you have a $100,000 flexible rate loan somebody is paying you and we would like to swap, then we can buy an interest rate swap. FLG gives you a check every month for the amount of interest he's getting paid and you give him a check every month for the amount of interest you're getting paid and we've transfigured our loans from fixed to flexible or vice versa. In practice, however, all that is exchanged is the difference between the two monthly checks, but that ends up being the same thing.

These aren't difficult to understand, are they? FLG didn't think so.

In fairness, the difficulty really comes from the pricing mechanisms. How much is an option to buy euros at a some price worth when that option expires in 30 days and the price of the euro is currently less than what the option specifies? That can get confusing for people without a finance background. But the basic explanation isn't that tough and FLG thinks explains why these things are useful.

This is why FLG gets so irate when people like Michael Moore call them bets. They aren't simply bets. Or it's as much of a bet as buying a stock is a bet. That term sorta applies in some cases depending on the intention of the buyer, but it's not like betting in a casino. There is an economic usefulness in being able to swap currencies or interest rates that a slot machine doesn't offer.

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