Equities and Derivatives
As we will discuss" financial assets "and" derivatives ", let me begin with an introduction, for those not familiar with this terminology, what are these things. A financial asset gives, in general, entitled to a future (and uncertain) stream of payments, which comes from some "source" and that occurs in "certain circumstances". The specification of the type of "source" helps us to distinguish between two types of financial assets, based on the nature of their "source." Let's call the first "securities positive net supply "and the second" no net supply securities "or, in short," actions "and" derivatives. "Obviously, the actions in the strict sense and the classical derivatives (eg options) are special cases of this I call here "actions" and "derivatives".Why we can speak of "actions " there must be some real investment (a tree, a horse, a house, an oil field, a society, and so etc.) on which income (uncertain) the owner is entitled to a right of action. These investments are "real" and actions should reflect its value, hence the definition of title to positive net supply. Note that, although not there is slavery, the existence of intellectual property rights and other contractual instruments makes it possible for operations give legitimate rights to the fruits (uncertain) of someone else's work, through the ownership of the company where that someone is working, and so on. I emphasize this point to make clear that a lot of "things" can be held through some kind of action. In fact, many are, and, theoretically at least, everything that has some potential for productive investment is a material whose possession can be structured through actions. As the annual flow of goods and services which we call GDP (in reality is much more of this, but never mind the details) is the product of physical investment existing and shareholder value is nothing than the present discounted value of the fruits (uncertain) products from some real investment, we obtain the following simple implication, that is relevant to understanding the mess we find ourselves.
The market value of all the "action" is the same as (ie, where the possession of all the productive investment was represented by shares) to the discounted present value of all future GDP (expected) and investment existing can produce. In other words, the market value of all shares of a country (or world, if you like to think big) is upper bound to a multiple of current GDP (the country, the world).To give an idea of \u200b\u200bthe numbers involved, follow me in these calculations. Currently estimated U.S. GDP for 2008 to around 15 trillion dollars and my friend Ellen McGrattan (these numbers knows them well) estimates that the stock of U.S. capital (including buildings) is about 4 times as much (Ellen, I of-thumb). That is about 60 trillion dollars. Now, this calculation is a bit 'distorted, given that the GNP also contains the fruits of labor, and labor are taken into account in the stock of capital in the form of shares, only very, very partially. So, wanting to adhere strictly to the theory, to 60 trillion must be added the value (implicit) capitalized labor and human capital, bringing the number to around 150 trillion dollars - to do so, given that the capital gain is just over 1 / 3 of GDP and assume that the return on human capital and labor in terms of GNP is about the same as what economists call "physical capital". If you add this value (implied) of all the other things produced but not traded on the market (your dinner, cooked for the party, or your shirt clean and ironed if you do it alone, or the market value of do or not do other things, more pleasant to read, et cetera) you may get an even bigger number, and I have no idea how it can be. Let's say 300 trillion dollars: what matters is that it is a finite number.
Now, we move to derivatives: financial securities to net supply anything. Instead of action, which, to exist, it only requires one person and a single investment, a derivative looks a bit 'to a tango it takes two (people) to do it, but the real investment is not strictly necessary. How it works. Mr. A says to Mrs. B: "if X event happens on a designated day D, I'll give you $ 100, otherwise you do nothing, what are you willing to give me today in exchange for my word on this promise?". If B says: "I give P-dollars" and A says, "ok", was born a derivative. Obviously what A tells B may be very complicated and can involve a lot of different circumstances (ie if X happens to date, I pay 100, but if we expect Y to D 'where, if X happens', then pay 40, but if it happens Y' then promissory notes 3 and if it happens Z 'then expect D'', et cetera). The things that can happen is all those conceivable and observable - or rather, anything that A and B will observe the date on which they agree when they dance together (oops, when they create a derivative). And once they get to D, who knows ... it is relevant to our reasoning, but do not make me jump too far ahead - and the payments going in both directions. In any case, when A and B create a derivative agree on a price P> 0, which is paid, say, from B to A. At this point we are in the hands of Fortuna : B D in hopes that the good to happen (at least for her) in the event and hopes to keep the word, or rather, is able to maintain it and pay.
Now, note this is: a derivative is not, in this sense that I hope is clear, nothing to do with real investment and with their product, at least in principle. Of course, many derivatives are constructed in relation to the behavior of some real underlying investments, or at least, such actions (see here for more technical details) but this is not necessary. When you bet $ 10 with your friends that it will rain tomorrow in San Francisco have created a derivative, and so when you purchase some form of insurance for your car, or when you buy a lottery ticket: everyone is trading in derivatives since ancient times and we do it, not c 'you need to have a PhD in physics or go to the Chicago Board of Trade to do it! For this reason, the number and, more importantly, the existing potential value of the derivatives at any moment is endless ...! Well, actually not, because if it were properly priced and if things were done properly, their value should always be 0: no titles in net cash, or "zero-sum games, if no coffin, "as I like to call them. To summarize: (i) an unlimited number of derivatives can be created, irrespective of investimeti productive" real "(II) if" properly priced "and if all players play correctly , the total net value of the complex derivatives created is still zero, (III) derivatives are instruments or to make or to bet, since the two things in fact the same sign to invert (IV) derivatives are securities re-distribution They are not associated with the creation of new productive investment (which is the role of actions in the broadest sense), but to redistribute wealth from A to B or from B to A based on the outcomes of random events over which players are previously granted, these events that they believe they can observe and whose probability can be estimated.
How, theoretically, the derivatives markets
Among other things, the facts listed so far imply that, when the markets are working "properly", a change in the value of a derivative may, in itself, not mean nothing to the value of the total real investment and vice versa. A change in the real value of an investment will be reflected by a change in value of representing him. The change in value of derivative that may have been written "about" that action (real investment) only determines who among our people A and B, will gain from the change in value of real and who will lose. Moreover, the facts listed above imply that when the underlying investment value (action) change of △, the secondary member can produce gains (losses) for A (B) equal to many times △!Since this is very important, let me develop it using the simplest example given before. Let's say you offer $ 50 B to A, in exchange for a promise that "if the event X occurs at the time D I pay you $ 100, otherwise you do not pay anything," and to accept, so that they can dance the tango. Well. We have to believe that - for whatever reason, I have no intention This article getting into how people construct their expectations, talk De Finetti (or with my friend Paolo Siconolfi that, contrary to De Finetti, is still alive and doing very well) - that there is 10% chance that X will happen to date, and 90% will not happen. If A does nothing (A) is taking a risk: true, there is only one case out of 10 X which occur in D, but if it happens, $ 100 to A to B and B has given him only 50. Because, to put it simply, D is tomorrow and missing five minutes to midnight, no interest accrues on those $ 50. So either (i) A has its own funds to cover the 50 missing when bad luck would (pardon, X happened) or (ii) To make sure that I will tell you as soon, or (iii) is planning to cheat, which is to say that A is taking a risk: the risk of failing on its promise (the daughter) to B . Before you follow the paths in the dark forest of modern finance on Wall Street that (iii) it opens, let me follow (ii) for a moment, that is the way that books usually teach finance and financial markets should be adequately regulated and normal follow.
In "normal and well-regulated financial markets" adhering to (ii), one of the following (and essentially equivalent) should things happen. A regulator - no need to be the government, could be a reliable third party who is vigilant about A to B and that it is really impartial (ie not as S & P or Moodys ...) and who has the power to enforce its rules - somehow will force A to put aside $ 50 or more (more than 50 A has just received from B) or whatever a good father would consider worth $ 50, to take precautions when X happens. This can be done in a lot of ways: for example, A can ask to look a lot (N) of people like B, enter into such derivatives with them until the law of large numbers can realistically keep. Suppose N = 100 is enough because the law applies. Then A has received $ 5000 and could having to pay 10000 if X happens. Since the probability that X happens 100 times in D is infinitely small (as is likely to happen 99, 98 ,..., 51 times), A (and many B) are not in danger of failing. Not occur until more than 50 X in D, A has funds to pay for that which he owes to B-designate. There are other ways in which a well-regulated market can achieve the same result. For example, you may ask A to "reassure" its risk with C, which has the necessary funds for the case in which X occurs more than 50 times, or it can be asked to sell some of the other derivatives that has types of C that can cover their payments, and so on. Notice how, in all this, many other derivatives are created from the original, and because the process of selling the same bet (or bets on the original bet, or bets on bets on bets ...) can be repeated an infinite number of times, the value Notional complex derivatives originated from that initial simple contract between the first A and first B can become very, very, very big.
In all these cases, however, if the theoretical mechanism was working correctly, the (many) A bet that they would be able to honor their commitment if X happens. To understand this, imagine that the event X in the original contract was "the market price of your (ie B) house to fall by $ 10. "The house is a physical and bell'investimento B owns it entirely (the argument does not require loans, for now ...) but decided to" superassicurarsi. "Which is good, and derivatives allow him. The point is that the fall in the value of real investment is only $ 10 for the economy as a whole, and B is that the bear and this is why the (super) insurance. A must now $ 100 to B and, although there is a very long chain derivatives of A and B, from B to C. .. up to Z "," until you collect $ 100 (As these derivatives are satisfied ) and they end up in the hands of A, A to B can pay as the must. To achieve this requires three things: (1) an amount of at least $ 100 in money or "credit" should be available in the system, (2) none of the individuals involved coffin or is unable to take the money and pass it to the person Next in the chain, and, last but not least, (3) 100 dollars of product present, real and consumable (GNP), are available for delivery to B in exchange for his $ 100 nominal. These three conditions are crucial, but (3) it is even more: if there are $ 100 for the actual product and consumer, but only $ 100 of paper is consumed, prices will rise in proportion (perhaps those with long and variable lag of Milton) and B do not actually receive $ 100. You will receive only written down pieces of green paper inflated.
Sometimes strange things happen
emphasize that in our circumstances, the fact that (3) is not achieved is closely related to the occurrence of (iii) (not (ii), (iii)). At the moment this seems to be the way we (oh my God, not me: the Fed, the U.S. Treasury and all the other guys Powerful) claim that (ii) is happening when, in fact, (iii) come true. Before you get there, however, I need to analyze two other steps. First you need to get an idea of \u200b\u200bwhat the total value of derivatives in the U.S. today, so to talk about real numbers. Then, we must understand why neither (i) or (ii) are successful, and (iii) yes and no (none?) He's realized until the other day. The first part I do it now, the second, which is longer, you will have to wait until tomorrow or after tomorrow. The third section will discuss why the "solution" that we are pursuing would seem to be anything but a solution. This better be a solution for the lucky few to, but not for the many unfortunate B. Derivatives, remember, are redistributive mechanisms and is a (huge) redistribution of income and wealth that is spoken in recent days.few numbers and a puzzle
for tonight let me end with the estimates I promised. How big can be the notional value of derivatives, as a whole? Certainly very great. Remember, using the precise estimates of my friend Ellen, I had inaccurately estimated the total value of U.S. real capital around 300 trillion dollars. In the Wikipedia page linked below read:
Over-the-counter (OTC) derivatives are contracts That are traded (and privately Negotiated) Directly Between two parties, without going through an exchange or other intermediary. Products Such as swaps, forward rate agreements , and exotic options are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is unregulated. According to the Bank for International Settlements , the total outstanding notional amount is $596 trillion (as of December 2007) [1] . Of this total notional amount, 66% are interest rate contracts , 10% are credit default swaps (CDS) , 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are other. OTC derivatives are largely subject to counterparty risk, as the validity of a contract depends on the counterparty's solvency and ability to honor its Obligations.
"the over-the-counter (OTC) derivatives are contracts (privately negotiated) directly between 2 parties, without the services of other intermediaries. Products such as swaps, FRAs and exotic options are traded almost seems that way. The market OTC derivatives market is the largest, and is not regulated. According to the BIS, the notional amount outstanding is 596 trillion dollars (December 2007). In this notional amount, 66% are IRS, CDS 10%, 9% FEC, 2% are commodity contracts, 1% in shares and 12% other. OTC derivatives are largely subject to counterparty risk, since the validity of a contract depends the counterparty's solvency and its ability to meet its obligations. "
That is, only the OTC market (which, as you'll see is our main concern in this saga) has a notional amount which is double of my esteem "courageous" of the total value of the shares of any type, which also included those that do not exist because, for example, and for good reasons, slavery is prohibited. If we stare at what I have announced as an estimate of what Ellen is the outstanding capital stock of the United States, the ratio is 10 (ten). To these should be added that OTC derivatives traded on regulated markets, that the IBS estimated to be around to 400 trillion in 2006. Now these numbers are for the whole world, but even if assumessimo that those "on the U.S. economy" is only 20% of the total (and more), we'd be talking about 200 trillion in notional value of derivatives, against a capital stock that is currently around 1 / 4 and a GNP that is ... 5 trillion less than 1 / 10 of that amount. So the puzzle
: if only 1 / 10 derivatives "should be paid" (what does this mean and who should pay whom, we'll see him in the second part of the trilogy) where the hell would find the money? Even cramming the entire GNP of the United States in the gardens of the lucky winners of the "tango game", B call them, we not only hungry ... but we do not even 5 trillion. Peanuts, right?
Fine, but do not have the Fed and the Treasury two printers, one for dollars and one for the debt? Of course you do! Stay in line
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