Understanding Derivatives

[Jeffrey]

Source: https://youtube.com/watch?v=FLGRPYAtReo

¤=[Post Update]=¤

Source: https://youtube.com/watch?v=YP4zwoqewHI

Source: https://youtube.com/watch?v=FHSrRaN2298

[Jeffrey]

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Options Contracts

Options contracts, appropriately, imbue the holder of the contract with the right to purchase or sell the designated asset at a specified price. This specified price is called the strike price. It is important to remember that the holder of the contract incurs no obligation. He may decide not to exercise the option for whatever reason. However, the issuer of the option, called the writer, must buy or sell the asset if the holder does exercise the option. Options are temporary instruments that expire at a predetermined date. Options allowing the holder to purchase an asset are referred to as call options. Options allowing the holder to sell an asset are put options. In all cases, the writer of the option receives a commission called a premium.

Source: http://www.ehow.com/list_7161676_dif...-forwards.html

Source: https://youtube.com/watch?v=Xlskzfz_E5w

Source: https://youtube.com/watch?v=cjfaayvqpwE

Futures Contracts

A futures contract is a formal commitment to purchase a specified sum of a specific commodity on a designated date. Futures contracts have historically been used by industries using said commodities as inputs. For example, a large food processor may purchase futures in corn or other grain. Industrial concerns may acquire futures contracts in oil, copper, natural gas or other materials. In these cases, the purpose of the futures contract is to protect the firm from an increase in price of the raw materials it uses. However, many participants in the futures markets are simply hoping to profit from changes in price of such commodities. If a futures contract is purchased and the commodity's market price significantly increases, the holder of that contract may then sell it at a profit. This practice is called speculation.

Source: http://www.ehow.com/list_7161676_dif...-forwards.html

Source: https://youtube.com/watch?v=TClcxy4Ku28

Forward Contracts

Forward contracts are similar in many respects to futures contracts. Like futures, there are frequently used to sell commodities that are not immediately available for use. Unlike futures contracts, forward contracts involve two parties. Futures contracts are traded on an exchange, rather than being an agreement between two parties. Another key difference is that forward contracts are often made with no intermediaries. On the other hand, futures contracts are facilitated by brokers. While options and futures contracts are frequently used by speculators, forward contracts are generally used to reduce risk for the producers and consumers of a product, rather than as an investment.

Source: http://www.ehow.com/list_7161676_dif...-forwards.html

Source: https://youtube.com/watch?v=SFCWGauR4qo

[Jeffrey]

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Assets

An asset is anything of value that can be converted into cash. Assets are owned by individuals, businesses and governments [...] Assets are often grouped into two broad categories: liquid assets and illiquid assets.

Source: http://www.investopedia.com/ask/answ...s-an-asset.asp

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Securities (finance)

A security or financial instrument is a tradable asset of any kind. Securities are broadly categorized into:

• debt securities (such as banknotes, bonds and debentures),
• equity securities, e.g., common stocks; and,
• derivative contracts, such as forwards, futures, options and swaps.

The company or other entity issuing the security is called the issuer. A country's regulatory structure determines what qualifies as a security.

Source: http://en.wikipedia.org/wiki/Security_%28finance%29

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Liquidity

1. The degree to which an asset or security can be bought or sold in the market without affecting the asset's price. Liquidity is characterized by a high level of trading activity. Assets that can be easily bought or sold are known as liquid assets.
   
2. The ability to convert an asset to cash quickly. Also known as "marketability."

Source: http://www.investopedia.com/terms/l/liquidity.asp

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Equity

1. In the context of a futures trading account, it is the value of the securities in the account, assuming that the account is liquidated at the going price. In the context of a brokerage account, it is the net value of the account, i.e. the value of securities in the account less any margin requirements.
   
2. Ownership interest in a corporation in the form of common stock or preferred stock.
   
3. Total assets minus total liabilities; here also called shareholder's equity or net worth or book value.
   
4. Real Estate: The difference between what a property is worth and what the owner owes against that property (i.e. the difference between the house value and the remaining mortgage or loan payments on a house).

Source: http://www.investorwords.com/1726/eq...#ixzz2QJIqpqh5

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Hedge

Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.

Source: http://www.investopedia.com/terms/h/hedge.asp

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Leverage

In finance, leverage (sometimes referred to as gearing in the United Kingdom and Australia) is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:

• A public corporation may leverage its equity by borrowing money. The more it borrows, the less equity capital it needs, so any profits or losses are shared among a smaller base and are proportionately larger as a result.
• A business entity can leverage its revenue by buying fixed assets. This will increase the proportion of fixed, as opposed to variable, costs, meaning that a change in revenue will result in a larger change in operating income.
• Hedge funds often leverage their assets by using derivatives. A fund might get any gains or losses on $20 million worth of crude oil by posting $1 million of cash as margin.

Source: http://www.businessdictionary.com/de...#ixzz2QJPXTBGp

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Margin

1. Borrowed money that is used to purchase securities. This practice is referred to as "buying on margin".
   
2. The amount of equity contributed by a customer as a percentage of the current market value of the securities held in a margin account.

Source: http://www.investopedia.com/terms/m/margin.asp

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Source: https://youtube.com/watch?v=yTxxSTXg404

[Jeffrey]

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What Is the Connection between Derivatives and Risk Management?

Derivatives are used for speculation and risk management. The connection between derivatives and risk management are exhaustive. Derivatives are used by corporations and financial institutions to create trading strategies designed to mitigate risk. Individual investors can use derivatives to create risk aversion methods that provide potential profit objectives. Derivatives and risk management techniques offer a virtually unlimited variety of market performance strategies.

Over-the-counter (OTC) derivatives are used by financial institutions to create custom strategies designed for specific trading situations. Exchange traded derivatives are commonly used by institutional and retail investors to speculate and hedge financial markets. Counter party default is eliminated by the use of exchange traded derivatives because all trades are cleared through a central clearinghouse.

Retail investors access derivatives and risk management systems through futures and options exchanges. Futures exchanges offer derivatives on commodities, currencies, equity indexes, and financial securities. Futures contracts are derivatives designed to purchase or speculate on the future price of an asset. Major corporations use futures contracts to manage the risk involved with buying and selling commodities. Farmers use futures contracts to hedge weather conditions and crop production.

Options contracts are derivatives used for speculating and hedging equities, futures, and other financial securities. Trading options involves the buying and selling of puts and calls. Simple and complex positions can be created to manage risk in a variety of market conditions. Derivative contracts are highly leveraged and afford the opportunity to control large amounts of assets with a relatively small deposit.

Hedging techniques are designed using derivatives and risk management methods. Hedging a position in a security involves limiting or offsetting the risk of an adverse price movement. The leverage available with derivatives make them the ideal financial instrument for hedging investments. Option premiums are paid to hedge portfolios against adverse market declines including systemic and market risk. The premium paid is a small percentage of the account value and is used much like an insurance policy.

Derivatives are a cost effective means to employ risk management tactics for hedging and protective purposes. Custom tailored strategies can be created to accommodate retail as well as institutional investors. International commodity trading depends on risk management solutions provided by futures derivative contracts. Risk management techniques are best employed through the use of derivative products.

Futures and options are the most common form of derivative trading. Retail traders use these markets primarily for speculation on a wide range of securities. Risk management and hedging products are available to the trader interested in protective strategies.

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What Are the Pros and Cons of Financial Derivatives?

Financial derivatives are generally contracts agreed upon between two parties whereby the values of the contracts are tied to the values of some underlying financial instruments, such as stocks or commodities. Using derivatives can be an effective way for investors to hedge the risks they have incurred from purchasing other securities. It can also be a way for an investor to speculate on the price of some security at a fraction of the cost of actually purchasing the security. The downside of financial derivatives is that they can be extremely complex and can lead to heavy financial losses if not executed properly.

Most casual investors only think of investing in terms of stocks or bonds. These are relatively simple instruments but they represent only a small portion of the investment opportunities available. For more advanced investors, financial derivatives, like options or futures contracts, are often valuable for both their flexibility and relatively lower costs. To put it simply, a financial derivative derives its value from some underlying instrument. Derivatives can be effective investment tools, but, like all investments, they carry significant risks as well.

Many investors use financial derivatives primarily as a method of hedging the risk of other investments they have made. For example, imagine that an investor has heavily invested in the stock of a certain company. To hedge his or her risk, he or she could buy an option known as a "put," which confers the opportunity but not the obligation to sell shares of that stock at a predetermined price. In this way, the put can offset the risk of the price of the stock plummeting.

Investors who prefer to speculate on the prices of stocks or other securities can use financial derivatives as a way of doing so. Derivatives contracts can usually be bought and sold at a small percentage of the actual price of the underlying instrument. Since this is the case, investors can take on the relatively small price of the derivatives contract and hope to reap the rewards in the future if the price of the underlying security moves in the expected direction.

As with all potential investments, financial derivatives carry significant risks. Derivatives can be extremely complex, and the casual investor might not understand the risks involved. In addition, many investors use leverage to become involved in derivatives, which means that they are essentially borrowing money from their brokers to make the investments. Such leveraging can be particularly damaging if the derivatives perform poorly.

Source: http://www.wisegeek.com/what-are-the...erivatives.htm

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Source: https://youtube.com/watch?v=X3nS5kSce_M

[Jeffrey]

Spend about an hour on the first four posts. Then walk away from it, let it sink in a little. Come back later and re-watch a couple of videos and skim over the posts above one more time.

You will get it. It's really not that complicated. They make it seem really technical and advanced. Once you get a grasp on the concept it makes it easier to learn more about the role of derivatives and make better judgements about the consequences thereof.

This is what I've been learning the past two days. The aforementioned material is what finally struck an intuitive chord in my mind; a chord which my analytical brain could then grab a hold of.

Derivatives demystified!

Woohoo!



Oh yea, if you find a good video or know of a good explanation, please share it.

[Mandala]

Holy cow, my head is spinning.

[donk]

You should check out Patrick Byrne's deep capture blog, he's the overstock.com CEO...if you found this stuff interesting look into the DTCC. Most important quasi-governmental organization in the securities racket. Other key words: naked short selling, failure to deliver.

Really not that complicated if you put the time in, and mind blowing the rabbit holes right in front of all our faces.

Also, for dedicates, Enron: the smartest guys in the room ain't a bad place to start if I remember correctly. This stuff moves so fast, most of the stuff is historical at this point, and it's only a decade or two old. Hard to keep up

[donk]

I asked my advisor friend how the mechanics of a derivative like a CDO or something "hitting", paying off. His reply was "no one ever expected them to not pay off"...not exactly answering my question, and sounding a lot like condi rice.

They're supposedly contracts, and I am fairly certain most(that weren't buried in the bear Stearns/Lehman/AIG debacles) just don't get paid. I used to follow this stuff closely, but it is so depressing & infuriating. They just keep changing the rules and sweeping fraud under carpet--in front of the whole world, who all just play along.

¤=[Post Update]=¤

Ironically, this is the stuff that lead me to the spiritual path. Trying to understand what a dollar really is.

[mgray]

Very good post. Appreciate it.
These "instruments" are the very reason we are still in an economic mess 5 years after the blowup.
You could have an "asset" like a home loan in the US be included in three-to-four "instruments. With that same mortgage being an asset on one set of books and a hedge on another set of books through these complex trading operations.
So when the homeowner goes bust the unwind is nearly impossible because its in so many trades.
I've simplified it a bit, but when a traunche or 100s of these instruments go bust its not a wash out trade it has exponential impact.
Hence liquidity dries up between banks, because they still don't know their true exposure. Think JPMorgan's London Whale trade.
Then the Central Banks need to pump money into the system to create liquidity and the banks figure why make home loans with risk, when all we have to do is tap Bernanke's pocket for cash.

[donk]

You could have an "asset" like a home loan in the US be included in three-to-four "instruments. With that same mortgage being an asset on one set of books and a hedge on another set of books through these complex trading operations.

Exactly, nice point--and we need to simplify it, because it is simple. I pointed to deep capture because it shows the most basic way they do this...and it is very simple and we can't fix the system if we don't acknowledge this problem: counterfeiting. This is the just of how you do it with stock certificates:


Dedicated more easily do it with every kind of "asset", especially loans. Unless the system goes back to obeying the laws of thermodynamics (& common sense, and criminalizing theft), it is not possible to fix

In a way, the fed coming in to the US I believe is another form of this, "counterfeiting" the "value" of the dollar, especially when told or any standards (but the Feds word) backed it

[donk]

Here's a link to the info for his site, somewhere on there is a slideshow where he describes quickly and clearly the naked short selling mechanics:

http://www.deepcapture.com/introduct...ture-analysis/

It's important on many levels, introducing the idea of how these things (paper securities) move, are traded, and easily counterfeited, the DTCC that is the organization that does it (and allows fraud. I been to the building in NYC, they require two photo IDs in the building even for other floors, and had two visible assault rifle armed guards...in an office building), and the loopholes regarding delivery of stock. A crash course in market manipulation.

Also my other thought above was that the Enron movie was crash course on derivatives, again. I haven't seen it in years, but its telling that WTC7 had all the evidence against them, that the crime was securities (they created most types of derivatives, I think, at least commodities and energy based ones), i temember it being like a microcosm of the global situations...again discernment is required...but much valuable info

[naste.de.lumina]

Dear friends.
Great explanation Vivek.
Sorry, but in the new world that I am creating in my head, derivatives, bonds, assets, etc ....... simply does not exist.
The filth of the old ground with the old earth will be buried.
Pace.
Wander Brazilian

[Jeffrey]

Posted by donk (here)
Other key words: naked short selling, failure to deliver.

Thanks! I looked up naked shorting, and realized that I'd skimmed over the term a couple of times in other articles without knowing what it was exactly. Alright, so from the top!

Source: https://youtube.com/watch?v=gVCemVTOWQY

Source: https://youtube.com/watch?v=Z1LctxzEREE

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Short (finance)

In finance short selling (also known as shorting or going short) is the practice of selling securities or other financial instruments that are not currently owned, with the intention of subsequently repurchasing them ("covering") at a lower price.



Schematic representation of short selling in two steps. The short seller borrows shares and immediately sells them. The short seller then waits, hoping for the stock price to decrease, when the seller can profit by purchasing the shares to return to the lender.

Source: http://en.wikipedia.org/wiki/Short_%..._short_selling

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Naked Short Selling

Naked short selling, or naked shorting, is the practice of short-selling a tradable asset of any kind without first borrowing the security or ensuring that the security can be borrowed, as is conventionally done in a short sale. When the seller does not obtain the shares within the required time frame, the result is known as a "failure to deliver". The transaction generally remains open until the shares are acquired by the seller, or the seller's broker settles the trade.

Short selling is used to anticipate a price fall, but exposes the seller to the risk of a price rise.



Schematic representation of naked short selling in two steps. The short seller sells shares without owning them. He then purchases and delivers the shares for a different market price. If the short seller cannot afford the shares in the second step, or the shares are not available, a "fail to deliver" results.

Source: http://en.wikipedia.org/wiki/Naked_short_selling

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Alright, so let me see if I can create an example now.

Let's say that the price of gold is sitting at $1,600 per ounce and I think that in the near future that price will drop to $1500.

I have a friend that is willing to lend me some gold. I say, "Hey, buddy. Can I borrow an ounce of gold from you? I'll give it back in a week, I promise."

He agrees to lend me an ounce of his gold. Then, I immediately turn around and sell it on the market for the market price of $1,600.

A week later, gold has dropped to $1,500 per ounce. So, I take my $1,600 and spend $1,500 to buy an ounce of gold (now at a cheaper price than before).

1,600 - 1,500 = 100

I now have $100 that I didn't have before and I have an ounce of gold to give back to my friend. Therefore, I have made a profit of $100 short selling gold.

Usually, there is a middle man that requires a fee from that profit or the lender charges a small fee for letting me use his gold in this manner.

Okay, so that's short selling. I think I understand the principle now.

So, what about naked short selling? I think the following example may pan out to be a good one.

Imagine a goldsmith way back in time. At this point in time in his business local townspeople are paying him a small fee for keeping their gold safe in his vaults.

In return for the deposits of gold, the gold smith issues receipts in varying denominations according to how much gold the person has entrusted the goldsmith to keep in his vaults. These receipts are "as good as gold" and they are used in the market to facilitate trade.

The goldsmith also has another business. He lends his gold out at interest.

After a comfortable amount of his own gold has been lent out (a ratio which he calculated that determines the maximum amount of risk he is willing to take with lending out his own gold) he sits back and collects the interest.

The goldsmith makes money by selling his handcrafted jewelry, collecting fees for safeguarding other people's gold, and by lending out his own gold at interest (the actual gold or the receipts for the gold).

One day he gets an idea. The majority of his customers never take their gold out because the majority of trade is being facilitated by the proxy of the receipts he has issued. Why not create loans against other peoples gold with these receipts at a safe ratio? Then he could lend out much more paper gold and collect much more interest. Nobody will know as long as a certain threshold of people don't ask for their gold back all at once.

He continues to do this until people start getting suspicious. Eventually, the people find out. Instead of reprimand, a new system of cooperation is developed using the scheme that the goldsmith hatched.

Now, instead of paying a fee to the goldsmith to safeguard their gold; the goldsmith pays the people interest on their gold deposits because the people know that the goldsmith will lend out their gold at a higher interest rate than they are being paid. This way, everyone makes a profit and a service is provided for the general good of the public. This is how banking was born.

After all this continues for a time, the goldsmith gets another idea. The receipts are "as good as gold" and it's these receipts, these convenient certificates, that are being used in the market as a proxy for the hard currency. Since this is the case, and he's already maximized his methods for profiting off of his own gold and the gold of others, how can he squeeze out more?

He decides that he can just create receipts to lend out that aren't backed by gold. He doesn't have enough gold in his vaults to back these new receipts, but it doesn't matter because the value of the gold (in the eyes of the public) has been transferred to the pieces of paper that the goldsmith has issued to them. This way he can collect interest by lending out receipts for gold that doesn't even exist in his vaults.

Whew! I think this last idea of the goldsmith's illustrates the first principle of naked short selling. Lending something you don't own with the hopes of making a profit.

The goldsmith hasn't borrowed gold from the goldsmith in the neighboring town to cover these new receipts. What happens if all the people want their gold back from his vaults? A majority of them may be able to get it back, but some people will not because the goldsmith has issued more receipts than there was gold in his vaults (i.e. lending something you don't have).

[Side note: In the case of naked short selling, the "seller" sells something he doesn't own or hasn't borrowed. No matter. I think the metaphor here is fungible. Ha!]

It's possible, depending on how tumorous his enterprise has grown, that many people will not be able to get the gold they are entitled to (from labor, selling their goods on the market, and anything else these hard earned receipts were worthy of).

This is a failure to deliver on the part of the goldsmith. He loaned something he didn't have, or didn't borrow, to make a profit. Usually this scheme worked out well for the goldsmith and he made a lot of money. The risk is that the people will want their gold back in their hands. If this happens, there are two "noble" options (both still suck):

1. Some people get all their gold back, some are left with nothing.
   
2. The value of each paper receipt is readjusted (lowered) so that the total amount of receipts issued now reflects the true amount of gold on deposit. In this case, everybody gets a portion of the gold they've earned/deposited back, but they've essentially been fleeced.

This is the ultimate naked short selling scheme. The time frame for repayment in this case has been manipulated and controlled by the bankers at the highest levels. How? They've ensured trust in the paper receipts to ward off people making a run on their gold in the vaults. The entirety of the mechanisms employed by the bankers eventually became legalized and the ensuring bankers turned into insuring government agencies. All to build faith in their system, and extend their time frame.

Source: https://youtube.com/watch?v=0Ga1uomzitM

It's their system. Vast empires were able to arise and commercially expand based on this system of credit (and fall by the same token -- or lack thereof). People were able to be controlled by the flow of these papered proxies. Why? The governments and monarchies were (and still are) dependent on this very system, and they are the ones that are supposed to regulate the people. The people are supposed to make the laws (a republic) by proxy of congress and the whole system of voting (a democracy). Elected officials don't get elected without money. Lots of money. It's a prerequisite. Who has the most money and therefore the most influence? The people behind the system of money.

In the same way that the paper is a proxy for the gold, governments are a proxy for the families behind these parasitic, gargantuan banking systems.

Globalization depends on this system.

The paper receipts aren't even backed by gold anymore. They ended up being backed by nothing but more paper, and eventually just debt.

Anyways, I'm getting off on a tangent. I'm sure that simpler examples exist, but I thought the principle of naked short selling could be applied here (although it seems like a long investment in this case).

Maybe it's a stretch, but it makes sense in my head!

[Jeffrey]

Posted by naste.de.lumina (here)
Dear friends.
Great explanation Vivek.
Sorry, but in the new world that I am creating in my head, derivatives, bonds, assets, etc ....... simply does not exist.
The filth of the old ground with the old earth will be buried.
Pace.
Wander Brazilian

Hello,

I'm with you my friend. We've got to understand how this works in order to avoid repeating the same mistakes.

[Deej]

Posted by Vivek (here)

Posted by naste.de.lumina (here)
Dear friends.
Great explanation Vivek.
Sorry, but in the new world that I am creating in my head, derivatives, bonds, assets, etc ....... simply does not exist.
The filth of the old ground with the old earth will be buried.
Pace.
Wander Brazilian

Hello,

I'm with you my friend. We've got to understand how this works in order to avoid repeating the same mistakes.

I'm glad to hear I'm among the like minded and thank you Vivek for putting all this info together. Excuse me if I pass on understanding this any farther than what I already do.

Anytime finances become any more complicated than giving something of value for something of value, it becomes a "financial instrument." In my experience, financial instruments only benefit those making money with money.... not offering anything of real value!

[aranuk]

Many thanks Vivek for all these educational vids you posted. Excellent teacher!


Stan

[Dennis Leahy]

Thanks, Vivek.

Marked for a thorough view when I have time. I know that whenever I try to give an explanation of derivatives, it comes out poorly, (meaning I don't have a clear enough understanding), and hope this will make it easier to convey.

Hopefully, the tie-in between mortgages, mortgage-backed securities, and the Federal Reserve is mentioned somewhere in the derivatives game.

Dennis

[Jeffrey]

Posted by Dennis Leahy (here)
Hopefully, the tie-in between mortgages, mortgage-backed securities, and the Federal Reserve is mentioned somewhere in the derivatives game.

Dennis

Source: https://youtube.com/watch?v=wfqvSSGKJIA

Source: https://youtube.com/watch?v=bx_LWm6_6tA

I don't think the reason for mortgage backed securities is for banks to "free up capital" as stated in the video. As I understand it, capital isn't really tied up when a loan is made. In fact, when a loan is made by a bank it actually creates more capital for the bank. In effect, mortgage backed securities are a shrewd and irresponsible way for the banks to make even more money.

I can see how these instruments can be considered as derivatives. Actually, they are probably packaged in options contracts which are traded on the derivatives market. If that's the case, it's even more fecked up. I can see them being tied to futures contracts as well. I think. I'm still reading.

The underlying reason for buying the mortgage backed securities (MBS) is based on the prospect of profits -- it's speculation minus the risk.

If the mortgages get repaid then the it's a good long term investment. The only risk is that the homeowners default on the loan. That risk is abolished by the fact that the house is the collateral and houses tend to increase in value over the long term.

This presents another risk though -- what if the property values of their forclosures drop and the investors/banking institutions lose a ton of money and default on their own promises to repay borrowed money?

This final risk is avoided by government bail out programs. If the scheme falls apart, the government will just give them enough money to start back up again (and keep their monstrous bonuses for a job well done). None of them will even admit to wrong doing because humanity isn't their first priority -- it's profits. It's a money game to them. Their whole life is based around making money and hedging risks. The possibility of losing money is the only thing that will retard their ethically blinded tendency to make money at any cost. That cost being the livelihood of the general public.

In the end, the risks are extremely minimal and the temptation of profit overrides any sense of morality or fiscal responsibility.

Unless the government refuses to bail out these financial institutions, there is no risk. That is another risk though; what if the government refuses to bail them out?

Well, that risk is covered by the mechanics of a bail-in program. The first of which is being tried in Cyprus. The accountability for the eventuality gets passed around just like the initial risks of the investments. Both of these things (the risk and the accountability) fall on the shoulders of the people who don't know any better. When are we going to see the bastards behind these types of rackets in jail?

It makes me angry. It also makes me want to learn more about it. Seriously, this is ridiculous.

Maybe somebody else can help explain this to me. Reading about it, it seems that futures, forwards, and options undermine the mechanics of a free market.

I can see the benefit for some companies in certain instances; hedging risks for unpredictable, possible variables.

They aren't gambling, they are playing it safe. Yet a lot of derivatives trading seems to be based on the same principles of gambling -- not playing it safe. High risk equates to big payoffs or huge losses.

In the case of speculation it seems like the money is being exchanged through these securities and stocks in a way that doesn't reflect their true value -- which is supposed to be dictated by the market.

The money is supposed to move through these the veins of stocks and bonds in ways that reflect their market-derived value. This doesn't happen the way it's supposed to when these assets are tied up in derivatives contracts.

When the market naturally causes prices to fluctuate, the financial instruments they are tied up with in the derivatives market are traded with contractually prescribed, artificial values. They are artificial because they were created based on speculation and they don't reflect the market value. This is why I think that they undermine some of the basic principles of a free market.

I'm not talking about the instances of commodity dependent companies that are trying to hedge their risks using derivatives. I'm talking about the options trading and futures contracts that are bred out of pure speculation.

It seems that it would make things lopsided and screw up the true, collective value of the asset being wagered. I'm still reading, but that thought popped up in my head.

Exaggerated gains and loses, facilitated by the derivatives market, makes for big swings in money transfer. It makes me think "volatility" which is a bad word in finance.

[Jeffrey]

Source: https://youtube.com/watch?v=Dl8Ywc6G5g8

[Ba-ba-Ra]

Here is a simplistic layman's explanation of real estate derivatives.

The bank makes a mortagage to Mr. Smith.

Someone or a group of someones (institiution) then bets that sometime in the future Mr. Smith won't be able to make his mortgage. That bet is a derivative. A derivative is betting on what is going to happen in the future.

The problem then began when the bank's that made the mortgages realized that if they lowered the qualifications for borrowers to get loans, that they (the banks) and their buddies could bet against them (buy a derivative) because they were pretty sure the derivative would pay off, because the borrower's ability to pay (which they had purposely reduced so the borrower would fail) was not realistic.