Highly recommend this site for people who have trouble following all the chatter about CDSs, CDOs, and so forth. It's pitched at an intelligent, but not particularly financially literate audience, and does a really nice job of explaining things.
That site is really quite excellent and informative. I had only a passing familiarity with derivatives and CDS before, but that site does an outstanding job simplifying an extraordinarily complex set of transactions in a way that is understandable but doesn't resort to the usual invective of just calling it "legalized gambling."
A question for Megan - in his October 21 post, he mentions that the State of New York already regulated AIG in the way that some people now want to regulate CDS markets. Is this accurate?
FWIW- He doesn't seem to be opposed to some form of CDS regulation, just to regulation that would impose capital requirements on CDS traders.
Thanks for this link. I the role of CDS and various derivatives are missing from a lot of the discussions about the bailout, and thus people see the problems and solutions as being far simpler than they should be.
First, Megan thank you for posting an article about my blog.
Now, Rob, margin requirements are replaced with collateral requirements in the world of derivatives. They're basically the same thing, except margin requirements are exchange requirements and collateral requirements are contractual.
So, Rob, hate to disappoint, but players in the derivatives market love money, and they're not about to let a counterparty get way without paying.
As for your "interest only" observation, that's how financing is done outside the world of home mortgages and student loans.
OMG, thank you for pointing out this site. Something like this is just what I've been looking for, and I'm not sure I would have found it on my own. And Charles, great site. I'll be bookmarking that one, and I have a lot of reading to do.
Agreed, an excellent site and an excellent writeup. Thanks, Charles.
Mark, the "usual invective" of "legalized gambling" may be oversimplifying rather that providing useful explanation, but when I read:
Essentially any risk that has an objectively observable event and an objectively measureable associated magnitude can be assigned a financial component and allocated using a derivative contract.
I'll admit my first thought was:
Okay, so I'll build a wheel, with 36 numbers placed randomly around it, half of them black, half of them red. Then I'll add a green "0" and a green "00". We will then spin this wheel and drop a ball into it, and observe where the ball lands. A agrees to pay B $100, unless it lands on the number 13, at which point B pays A $3600 instead.
Doesn't that fit our descriptive paragraph above? Other than obfuscating the gambling through a layer of something tangible, (weather, interest rates, currency fluctuation, etc) what's the real difference here? If anything, roulette is safer, since we really have a better ability to predict the risk of "00" than we do the risk of rain...
Allowing market participants to speculate on the future value of assets is what allows markets to function. If it weren't for these "gamblers," people who actually have exposure to the price of oil, to the weather, and to interest rates would be stuck with that risk. Derivatives facilitate the assignment of risk to those willing to bear it. I think we can all appreciate the utility of that.
"Derivatives facilitate the assignment of risk to those willing to bear it."
As Charles pointed out, a key difference between a roulette wheel and the derivatives market is that the roulette wheel is simply inventing risk that wouldn't otherwise exist, purely so that people can gamble on that risk. Many of these derivatives, such as CDS, exist mainly to shift existing risk. For some to be able to hedge or insure their risk, others have to take it.
CDS allow risk to be diversified. Granted, they are set up in a way that does not guarantee that risk is only diversified. CDS could be used to speculate as well as to hedge, although the available evidence so far indicates that they have been used responsibly. If we tried to prevent all speculation, we'd probably have a less liquid market that made it much more difficult to hedge.
Thanks for pointing out that site! I'll recommend it to my finance students, who never know the terms as well as they should.
That site is really quite excellent and informative. I had only a passing familiarity with derivatives and CDS before, but that site does an outstanding job simplifying an extraordinarily complex set of transactions in a way that is understandable but doesn't resort to the usual invective of just calling it "legalized gambling."
A question for Megan - in his October 21 post, he mentions that the State of New York already regulated AIG in the way that some people now want to regulate CDS markets. Is this accurate?
FWIW- He doesn't seem to be opposed to some form of CDS regulation, just to regulation that would impose capital requirements on CDS traders.
Notice how derivatives allow you to get around those pesky rules like margin requirements.
His basic derivative, assuming A hedges by buying into DJIA, is essentially an interest only loan from A to B for the entire amount of the security.
Megan,
Did you read this post on that site, "The Not So Efficient Market (Theorem) Hypothesis"?
Ann,
That wouldn't be you mentioned in the post above, would it?
Thanks for this link. I the role of CDS and various derivatives are missing from a lot of the discussions about the bailout, and thus people see the problems and solutions as being far simpler than they should be.
First, Megan thank you for posting an article about my blog.
Now, Rob, margin requirements are replaced with collateral requirements in the world of derivatives. They're basically the same thing, except margin requirements are exchange requirements and collateral requirements are contractual.
So, Rob, hate to disappoint, but players in the derivatives market love money, and they're not about to let a counterparty get way without paying.
As for your "interest only" observation, that's how financing is done outside the world of home mortgages and student loans.
OMG, thank you for pointing out this site. Something like this is just what I've been looking for, and I'm not sure I would have found it on my own. And Charles, great site. I'll be bookmarking that one, and I have a lot of reading to do.
Obviously, the reason so few people understand derivatives, especially in journalism, is that few college students study Calculus.
Agreed, an excellent site and an excellent writeup. Thanks, Charles.
Mark, the "usual invective" of "legalized gambling" may be oversimplifying rather that providing useful explanation, but when I read:
I'll admit my first thought was:
Okay, so I'll build a wheel, with 36 numbers placed randomly around it, half of them black, half of them red. Then I'll add a green "0" and a green "00". We will then spin this wheel and drop a ball into it, and observe where the ball lands. A agrees to pay B $100, unless it lands on the number 13, at which point B pays A $3600 instead.
Doesn't that fit our descriptive paragraph above? Other than obfuscating the gambling through a layer of something tangible, (weather, interest rates, currency fluctuation, etc) what's the real difference here? If anything, roulette is safer, since we really have a better ability to predict the risk of "00" than we do the risk of rain...
Hi Geoff,
Allowing market participants to speculate on the future value of assets is what allows markets to function. If it weren't for these "gamblers," people who actually have exposure to the price of oil, to the weather, and to interest rates would be stuck with that risk. Derivatives facilitate the assignment of risk to those willing to bear it. I think we can all appreciate the utility of that.
"Derivatives facilitate the assignment of risk to those willing to bear it."
As Charles pointed out, a key difference between a roulette wheel and the derivatives market is that the roulette wheel is simply inventing risk that wouldn't otherwise exist, purely so that people can gamble on that risk. Many of these derivatives, such as CDS, exist mainly to shift existing risk. For some to be able to hedge or insure their risk, others have to take it.
CDS allow risk to be diversified. Granted, they are set up in a way that does not guarantee that risk is only diversified. CDS could be used to speculate as well as to hedge, although the available evidence so far indicates that they have been used responsibly. If we tried to prevent all speculation, we'd probably have a less liquid market that made it much more difficult to hedge.