E.g GS could have 1tr of gross notional of derivatives with JP but with zero risk or monies owed if the positions all offset (as indeed in real life they do, banks run very little net exposure).
But of course newspapers and grotty rags like to perpetuate this narrative that derivatives are going to blow up the world.
I apologize if I'm misusing terms - I'm not a finance expert.
The only explanation I can think of is that leverage is used to exploit dumb money that isn't hedged correctly. In which case, leverage is a barrier to entry that diminishes the number of participants in a market and reinforces cartel behavior. Which I would think is a bad thing.
E.g a simple interest rate swap: I agree to pay you 2% per annum on a reference notional of 100m for 10 years, and in exchange you pay me libor referencing the same notional. At the end of first year let's say libor fixes at 1.98%. Hence I pay you a net 0.02% (2% - 1.98%) of 100m, i.e 20,000. We do this every year for 10 years.
It is just a way to hedge interest rate exposure - e.g I have borrowed 100m paying a Libor-linked interest rate and don't want to run the risk that Libor spikes to 10% or whatever.
There's nothing complicated about this, at least in principle. Derivatives just allow people to hedge out exposures they don't want.
The idea of the interest rate swap is simply that some entities prefer to lock in a rate, others prefer to have it float. So they swap those risks.
The swap market provides a linkage between the money market ( borrowing < 1 year) and the capital market (borrowing > 1 year), and allows one to borrow (or lend) where the comparative advantage is better.
The 10 year swap rate is then a market number which represents the relative demand (and supply) within the money & capital markets.
It's no secret that Warren Buffet is strongly against these derivative products and considers them to be one of the most dangerous financial products in history.
So why is he "perpetuating the narrative" as you dismissively claim?
I want to bring him up because you're hiding behind attacking the newspaper and "rags", so let's instead point to one of the most successful investors in modern history who agrees.
Why is he wrong? Please don't hide behind dismissal and attacks, as a man of Warren Buffets caliber has proven through real world demonstration that he possess a vast understanding of these markets and products.
What would be intensely interesting would be if that derivatives number was broken down by type of derivative. That would be something worth discussing.
"If Powerball sells 1 million tickets at 2$ each, where the jackpot is worth 200,000,000$, is the size of that market 2M$ or 200 trillion $" [1]
[1] https://www.reddit.com/r/Economics/comments/3xb2xh/all_of_th...
What blows my mind is that it seems like everyone in the media has taken this obviously incorrect premise and run with it.
Their point would still stand if they sold 100MM tickets though, so as not to confuse the two issues (ie. the notional amount and the expected value), perhaps it would have been a better example that way.
Did you introduce a central bank into the example some point? Is this a repeated game? Am I missing something? If not, this reddit comment makes no sense whatsoever.
But as 2007 demonstrated the real world risk is not IID. And at 100x leverage a 1% movement can totally wipe out a bank.
Also it's not like the 2007 crisis was fixed in any meaningful way. The FED just bought 1.4 trillion of MBS derivatives and is now sitting on them, actual value still unclear. Probably to be paid by the tax payer through 20 years of austerity.
A shame because they weren't actually bankrupt - PWC has now recovered 100% of liabilities with assets to spare.
You can't treat mass psychology as an externality. Austerian policies rely in part on disciplining debtors to restore confidence in market transparency and the rule of law. If thousands of households lost their homes when their cash flow could not meet their debt payments, why shouldn't a bank go bankrupt when its cash flow cannot meet its debt payments? Lehman was just the bank that couldn't find a seat when the music stopped, and that's fair.
This is the sort of thing I mean when I say derivatives are hard to evaluate correctly. So yeah, Lehmans totally went bust because of their large amounts of trading in CDS.
The cash will be (by construction) the same tomorrow, but the shares could easily vary by a few percent.
Company valuations are projections created through some combination of extrapolation of growth or value and (often in the earlier stages) just agreeing on a number to make the percentages and such work out correctly. They are expressed as a dollar amount but those are not real dollars.
specifically this book: http://www.amazon.com/s/ref=nb_sb_noss?url=search-alias%3Dst...
https://en.wikipedia.org/wiki/Derivative_%28finance%29#Mortg...
Everything based on junk mortgages were junk.
What would they be called if they aren't derivatives?
Securitised bonds, which is a cash product.
The distinction between a cash & derivative product is really simple - one is leveraged the other isn't. E.g if I buy 100m of MBS I actually have to cough up 100m in cash - I am buying both the interest and principal repayments of the underlying mortgages.
On the other hand if I enter into an interest rate swap with 100m notional I don't pay anything at all (assuming traded at spot market levels, and ignoring initial margin). The risk, or sensitivity, to interest rates is the same on both, but am only paying out cash for the securitised bond.
Hence the bond, or MBS is "cash" and the swap is "derivative".
This could be the self-regulating limit for derivatives - the legal time required to unwind them in the case of mass redemptions, bounded by the business cycle length and statute of limitations for a locality.