What Is a Derivative?

From what I can gather, a derivative is a bet. So, as a financial instrument, it is sold in a gambling casino. A derivative has nothing to do with the production of goods and services - it's just something to invest in to make money and have fun gambling.

My understanding is that the main cause of the financial panic of September 2008 and the banker bailout is derivatives. So, it seems that the U.S. taxpayer is supporting a gambling casino.

I also understand that derivatives used to be illegal.

Typing this I'm starting to get mad. I keep hearing about Goldman Sachs being "financial terrorists." I hear that from Max Keiser. He seems to know what he is talking about.

I know the U.S. Congress is bought and paid for on both sides of the aisle. But, I'm wondering whether some of them are starting to have little twinges of a guilty conscience about what's happening to people worldwide as a result of this thing called "derivatives."

A derivative is a contract written on a security between multiple parties, usually two, and which bind the parties to the terms of the agreement based on the outcome of the security. Hence, a "derivative" is "derived" from the movement, change, alteration,...etc. of other financial instruments.

There are many kinds of derivatives, with the most notable being swaps, futures, and options. However, since a derivative can be placed on any sort of security, the scope of all derivatives possible is near endless. Thus, the real definition of a derivative is an agreement between two parties which is contingent on a future outcome.


Derivative

10 Myths about derivitives

reply to post by Mary Rose


Yeah its a bet of sorts, but it allows transfer of risk. If you want to get angry, get angry at the american legal system that allows people to walk away from their houses (handing them back to the bank in effect) and get angry at all the idiots, and there are lots of them, that bought CDO's, CDF's and a myriad of other "bets" on outcomes based on housing...

Funny how noones whinging about your typical options on everyday shares... if there is such a thing anymore.

Dave

In this article dated April 27, 2010 by Webster Tarpley, he states that the $1.5 trillion in subprime mortgages should be compared to the $15 trillion U.S. residential real estate market and the $1.5 thousand trillion world derivatives bubble.

In principal derivatives are fairly innocent. It is a bet, of sorts, but so are all investments: you "bet" on the value of your investment increasing while acknowledging the possibility that it may not increase. The perceived odds of the value increasing or decreasing, and by how much, determine the market value of an investment.

The origin of modern derivatives comes from agriculture. When a farmer decides to plant, say oranges for example, he has to devote some percentage of his time and money and field space and all other resources to growing the oranges. However, he doesn't know what the value of those oranges will be in the market however many months from now when he goes to sell them. He can buy a derivative which says "if the value of the oranges is below a certain level, the farmer is owed some amount of money by the person who sold him the derivative." In this way, the farmer is transfering his risk. Now, he doesn't have to worry about the oranges decreasing in value because he has the derivative which will pay him if the oranges are low in value when he goes to market.

In the above case, if the value of oranges is high, the seller of the derivative owes nothing, and makes a profit from the farmer. If the value of oranges is low, the seller of the derivative loses money, and the farmer makes more money than he would by just selling the oranges at their decreased value.

This simple case is innocent enough, but in reality the system is taken to rediculous extremes. Derivatives are sold on absurdly complex investment structures which are impossible to price; no one can accurately determine the value of these products. This is how we get into trouble: the finance people play games with made up investment structures and a whole lot of money gets mixed up in products of uncertain value. Then, when someone comes to their senses and realizes it's all BS, the value of these things plumets and everyone gets burned.

Originally posted by OnceReturned
The origin of modern derivatives comes from agriculture...

This is very interesting!

What you're describing sounds like an insurance policy...

Originally posted by Mary Rose
In this article dated April 27, 2010 by Webster Tarpley...

Webster talks about two types of derivatives that are often referred to as "toxic assets," "exotic instruments," or "troubled assets":

1. Synthetic collateralized debt obligations
   
2. Credit default swaps
   

[edit on 4/28/2010 by Mary Rose]

[edit on 4/28/2010 by Mary Rose]

Originally posted by damwel
10 Myths about derivitives

damwel,

I see this article is dated September 11, 1997 and it's by Thomas F. Siems, who was (or is) a senior economist and policy adviser at the Federal Reserve Bank of Dallas.

I'm curious to know whether you've read the article.

If you have, please give a summary of your opinion of what's said.

Originally posted by Mary Rose

Originally posted by OnceReturned
The origin of modern derivatives comes from agriculture...

This is very interesting!

What you're describing sounds like an insurance policy...

Oncereturned's post is indeed a good basic description of derivatives, and your connection of the idea with INSURANCE is exactly what you need to grasp to understand the fundamental nature of derivatives. As financial instruments, derivatives are are much closer to insurance in nature than they are to, say, stocks. In essence, they are CONTRACTS. Once you think of them in that light, the whole thing is easier to understand.

Derivatives certainly can, as noted, play a useful role, especially in agriculture. The first recorded use of "derivative-like" agreements were in relation agriculture during the Roman Empire.

One of the big problems in recent years is that new forms of derivatives have been put into widespread use that allow people to "insure" against events that have no direct connection to them. It's like being able to take out car insurance on your neighbor's car. Suppose you know that your neighbor is a massive drunk. You could take out insurance on his car and then send him a crate of whisky and sit back and wait to to collect.

Or, even more unsrupulously, imagine you are a used-car dealer. You have a bunch of cars with broken-down rusty parts and engines that are almost sure to fail. You sell them for super-low prices to a bunch of known alcoholics and then take out huge insurance policies that will pay YOU (not the car owner, driver, or victim) big-time if/when an accident occurs. You might even open up a bar at your used car-lot and practically give away the whisky and cars for free to speed up the process! The real payout isn't going to come from selling the cars (although you represent yourself as a "car-dealer" as your primary business). Rather, the real money is going to come from collecting the insurance when the drivers have accident after accident. This analogy isn't perfect, but this is close to the kind of scheme that Goldman and others on Wall Street are now are accused of.

[edit on 4/29/10 by silent thunder]

Originally posted by silent thunder
This analogy isn't perfect, but this is close to the kind of scheme that Goldman and others on Wall Street are now are accused of.

Thanks! You've helped me understand quite a bit.

Before I started this thread I did not know about the legitimate purpose for this financial instrument. I thought it existed just for the purpose of providing gambling fun for the elite.

So, it's not derivatives per se that are bad, it sounds like, but the lack of regulation. Is the problem the repeal of the Glass-Steagall Act in 1999, which removed constraints?

Originally posted by Mary Rose

Originally posted by silent thunder
This analogy isn't perfect, but this is close to the kind of scheme that Goldman and others on Wall Street are now are accused of.

Thanks! You've helped me understand quite a bit.

Before I started this thread I did not know about the legitimate purpose for this financial instrument. I thought it existed just for the purpose of providing gambling fun for the elite.

So, it's not derivatives per se that are bad, it sounds like, but the lack of regulation. Is the problem the repeal of the Glass-Steagall Act in 1999, which removed constraints?

That's part of the problem, and of other general problems, but not the whole issue in terms of dervatives. Glass-Steagall basically separated commercial banks (i.e., what most people think of as "everyday, normal banks") from investment banks (which are allowed to take bigger and different kinds of risks). From '29-'99, you had to be one or the other. That way, when granny went to put her life savings in a good old-fashioned savings bank (which is a commercial bank), she could feel safer because she knew that a bunch of high-flyers weren't taking crazy risks with her money. Investment banks always take more risks and thus get more returns -- or more intense flameouts, as the case may be.

For a long time, they were seperate, but when Glass-Steagal was repealed, they could merge. This gave the risky high-flyers a LOT more money to play with, and suddenly granny's savings weren't so protected anymore. The years since the 90s have seen a lot of financial regultion besideds Glass-Steagall relaxed, so the net result was that everyone was allowed to take more risk. Greenspan and others said it would all work out, because the risk would be distributed widely among the system and thus balance itself out. You'd actually have less risk of a catestrophic failure at any single institution. This was true, but they failed to see the flipside...by spreading out the risk throughout the system, they made the system iteslf rather than any individual company far more unstable than it had been since the 1920s at least.

Anyway, to extend the analogy using cars and drivers I used above, imagine that in a single town, five big car dealers all adapted the same strategy. Then, all of a sudden, there are a zillion car crashes (i.e., housing bubble pops). The biggest insurance company, called, for example "AIG", simply can't pay out the insurance policies because there have been too many car crashes. So the used-car dealers (i.e., the big megabanks) go to the government and tell a bunch of dumb, frightened senators (most of whom don't really understand what's going on with the scheme anyway) that the world will end. The senators shovel taxpayer money at the car dealers and also at AIG, and then the insurance giant is able to pay off some of the biggest car dealers (which in this analogy are certain big banks). Because of the nature of the loan, the insurance giant AIG is the one that ends up owing all the relief money back to the government, while the used car dealers get to take their big insurance payouts as massive profits, and walk away smiling.

Meanwhile, the city is filled with dazed, hung-over, bleeding victims of hundreds of accidents and burning hulks of worthless cars on every corner.

[edit on 4/30/10 by silent thunder]

Originally posted by silent thunder
That's part of the problem, and of other general problems...

One general problem causing the financial crisis that I'm sensing is what I've heard termed as "debt-based money supply."

I'm reading Web of Debt by Ellen Hodgson Brown, J.D. right now and have started a thread on her book. She will be speaking at a conference in May. I'm hoping her ideas will be discussed on the internet. I'm looking for solutions.

Originally posted by Mary Rose

1. Synthetic collateralized debt obligations
   
2. Credit default swaps
   

In another Webster Tarpley article dated April 24, 2010, Webster states that a synthetic CDO or CDO squared is a CDO that is concocted out of other CDOs.

He also states:

Credit default swaps represent bets on whether a given asset or company will go bankrupt or not. As such, they can be used as insurance against such an eventuality, or else they can be used to make money on the insolvency. CDS are therefore a form of insurance, but they are issued by counterparties who have not registered as insurance companies and who have not met the legal and capital requirements which are necessary to function as an insurance company. It ought therefore to be clear that CDS have been totally illegal all along, and have flourished only because of an outrageous failure by state insurance regulators to enforce applicable laws against the privileged class of financiers.

Additionally, he states:

... there are the so-called over-the-counter (OTC) derivatives, otherwise known as structured notes, counterparty derivatives, or designer derivatives. These often take the form of contracts which are kept secret by the counterparties, and which are often not included on the balance sheets of banks and other institutions which enter into these contracts. This type of derivative is currently not reportable to any regulatory agency. This secrecy is a result of the successful effort by Robert Rubin, Larry Summers, and Alan Greenspan to block the modest proposal of Brooksley Born of the Commodity Futures Trading Commission to bring the OTC derivatives into the sunlight during the second Clinton administration. Since these derivatives are not reportable at the present time, we must guess at their amount, and the best guess is that OTC derivatives make up almost $1 quadrillion of ultra-toxic speculation.

What you understood in the OP is what these scam artist in the Senate would want you to believe. I know this because you use the word "bet" that was programmed into your subconscious from the soundbite you most likely heard Levin or some other moron talking about in that hearing several days ago.

The derivatives they are referring to are OTC derivatives. There are many types, but the most common ones are financial (Index Futures) and commodity derivatives. These are regulated by the CFTC. They serve many purposes.

Example 1)

I am a speculator, I believe the price of wheat to be going up.

Outcome 1)

I am adding liquidity in into the market for major hedgers

Outcome 2)

My added volume allows for price discovery in the marketplace.


__________________________________

So there are many results and many different viewpoint you can have. This is just an example of 1 and 2 real world outcomes/results of my actions.

Just go to investopedia or something to look things up if you are confused.

[edit on 1-5-2010 by GreenBicMan]

Originally posted by GreenBicMan
What you understood in the OP is what these scam artist in the Senate would want you to believe. I know this because you use the word "bet" that was programmed into your subconscious from the soundbite you most likely heard Levin or some other moron talking about in that hearing several days ago.

No, I did not have anything programmed into my subconscious from a soundbite.

I've gotten my understanding about derivatives from Webster Tarpley primarily. I did not watch the Senate hearings.

Originally posted by GreenBicMan
The derivatives they are referring to are OTC derivatives. There are many types, but the most common ones are financial (Index Futures) and commodity derivatives. These are regulated by the CFTC.

Is the regulation adequate?

Perhaps what you're talking about here is different from what Webster is talking about when he describes "...(OTC) derivatives, otherwise known as structured notes, counterparty derivatives, or designer derivatives. These often take the form of contracts which are kept secret by the counterparties, and which are often not included on the balance sheets of banks and other institutions which enter into these contracts. This type of derivative is currently not reportable to any regulatory agency."

Originally posted by GreenBicMan
Just go to investopedia or something to look things up if you are confused.

You seem to think I'm looking for investment advice.

To the contrary, I started this thread because of my concerns about the role that derivatives is playing in the planned takedown of the United States through financial crisis and economic depression.

reply to post by Mary Rose


You wouldn't know if it was in your subconscious. They used the word "bet" about 100 times as have others on this website. Either way..

There is no planned financial takedown.

OTC Derivatives = Not Regulated

**You must be an institution to use these instruments. These instruments had nothing to do with what happened in this country. What happened in this country was due to over leveraging in all sectors, public/private/you name it.

When you get too over leveraged in anything you will blow up eventually. See most residential in FL about a year ago etc.

You need to understand the basics of leverage before you can understand derivatives. Please (as I said) go to investopedia and look at definitions if confused. It's not for investing advice, not sure how you came up with that.

Anyway, what is your real question?

Originally posted by GreenBicMan
reply to post by Mary Rose

 

You wouldn't know if it was in your subconscious. They used the word "bet" about 100 times as have others on this website. Either way..

My point was you were not aware of where I got the term "bet" from when you posted as you did.

Originally posted by GreenBicMan
There is no planned financial takedown.

According to my research the international bankers who control this world behind the scenes want a central, one-world government. That means taking down the United States.

Originally posted by GreenBicMan
OTC Derivatives = Not Regulated

Huh?

What about your statement:"The derivatives they are referring to are OTC derivatives. There are many types, but the most common ones are financial (Index Futures) and commodity derivatives. These are regulated by the CFTC."

Originally posted by GreenBicMan
What happened in this country was due to over leveraging in all sectors, public/private/you name it.

This may be true.

Originally posted by GreenBicMan
You need to understand the basics of leverage before you can understand derivatives.

Are you saying you don't have derivatives without leveraging?

Originally posted by GreenBicMan
Anyway, what is your real question?

My real question is what are the characteristics of this thing called derivatives that my research tells me is the culprit behind the financial crisis in the United States (and elsewhere).

To quote Webster again, there is a "$1.5 thousand trillion world derivatives bubble."

reply to post by GreenBicMan


Originally posted by GreenBicMan
OTC Derivatives = Not Regulated

Huh?

What about your statement:"The derivatives they are referring to are OTC derivatives. There are many types, but the most common ones are financial (Index Futures) and commodity derivatives. These are regulated by the CFTC."

What are you not understanding?

The OTC Derv. = Institutional Only and are NOT Regulated

Regulated Derv = Futures Contracts, Options, etc. expand from there..

That should help

_______________________________

No one brought down or is bringing down the USA bc of OTC Derivatives.

Derivatives inherently use leverage. Please go to a website to look up definitions and margin requirements. You will find your answers there better than I could plainly explain.

The CMEGROUP is a good place for this.

www.cmegroup.com

There is a library of information on derivatives there. They are basically a combination of the NYMEX,CBOT put together if you are familiar with the terms.

All your other assumptions are incorrect. What is your research and what are you basing this on? You should base your research around the CMEGROUP and start from there.

Once you understand time and sales etc. you will see it is tightly regulated. There are institutions that get fines as well for going over contract limits. Although meager I should say.

You are making broad generalizations in a very complex environment. You need to start with real information that isn't misinformation if you really want to be knowledgeable on the subject.

What else do you need help with regarding conceptualization?

Originally posted by Mary Rose
In another Webster Tarpley article dated April 24, 2010, Webster states...

All kinds of derivatives, be they exchange traded or over-the-counter, were strictly banned and outlawed in the United States between 1936 and 1982 . . . the Commodities Exchange Act of 1936 outlawed the selling of options on agricultural products. This law had the effect of blocking most derivative speculation, until . . . the presidency of Ronald Reagan . . . It should be added that derivatives were also banned in many states as a result of laws prohibiting gambling or forbidding bucket shops, which were betting parlors in which side bets could be placed on stock market fluctuations.

And...

...Obama’s Cooper Union speech of April 22, 2010 approvingly cites Warren Buffett’s remark that derivatives represent financial weapons of mass destruction. But Obama then says that derivatives nevertheless have an important and legitimate role to play. So which is it? Some years back, French President Jacques Chirac rightly referred to derivatives as “financial AIDS.” What useful purpose can these toxic instruments possibly serve?

...The recent Goldman Sachs scandal has underlined . . . that the Wall Street investment houses serve no useful social purpose whatsoever. They exist solely for the purpose of pursuing speculative profits through a process of looting and pillaging the rest of the economy. The Wall Street zombie banks are monopolizing US credit, while Main Street goes broke.

An article dated 19 April 2010 by By Greg Hunter of USAWatchdog.com entitled "Fraud, It’s Much Bigger Than Goldman Sachs" states:

...All of the big banks have been selling securities called derivatives for at least two decades. Derivatives are usually bundles of debt. There are derivatives for mortgages, car loans, credit cards, student loans and all types of government debt, to name a few. Derivatives are complex, but when it comes right down to it, you can sum them all up as debt bets. Derivatives are a $600 trillion market according to the Bank of International Settlements. (Some say the BIS estimate of the derivatives market is actually more than $1,000 trillion!) And here is the best part–derivatives are totally unregulated. That means there are no standards, no guarantees and no public markets. With no public market, there is no real way to price this kind of Wall Street alchemy. You just have to trust the person selling the “security.” Take the Goldman fraud case, for example. If there was a public market, Goldman would have never been able to pack crap loans into a security and sell them. The regulation and guarantees would not have allowed it. After all, regulations, guarantees and a public market make selling derivatives a lot less profitable. That’s why Wall Street has been fighting regulation of the derivatives market for years...