I’m sure this is going to sound naive and simplistic. Please forgive my lack of study. I have heard speakers such as Tom Woods make very complicated subjects easy to understand even though it might only be at a very introductory level. That is a great gateway to learning a subject fully. It provides the confidence to go further which I hope to do someday with Austrian Economics and the business cycle. My question to the readers of this question is, “Can you explain derivatives in a nutshell like Tom Woods so eloquently did with the basic principles of Austrian Economics?”. “Derivatives” is the word that I have seen people use to seemingly win an economic argument. They mention it. You don’t know it, therefore economics is too complicated for you. Of course, they don’t know anything about it either, so if you have even the most basic knowledge of the subject, you can continue with a logical conversation.
If I remember correctly a derivative is some financial instrument (piece of paper) which’s value depends directly on the value of an other financial instrument. Say, when I have an option to buy some share X at 20 dollars in October 4, the value of this option will depend on the expected price the share X in October 4rth.
I don’t see why ‘derivatives’ should be treated differently than every other financial instrument, piece of paper, or indeed material asset: the value of everything on earth depends of the value of other things. Setting derivatives aside is just a ploy to ask regulatory powers.
The reason they set the mortgage derivatives aside is because they amount to obligations worth tens of trillions of dollars and are sitting on the balance sheets of major financial players. So we’re not talking about just a few options here, we’re talking about a potentially devastating systemic risk. Now, whether or not that justifies the proposed regulations is another question entirely.
Also, many of them are totally uncollateralized and so all the counterparties would essentially go belly up if the contracts came due. This would cause a chain reaction.
The word “derivative” has come to mean so many things it’s really impossible to explain all of its meanings in a simple, coherent way. However, the basic idea is that it is a contract whose value is based on something else. It’s basically gambling: The buyer of a derivative is betting the value will go up, the seller is betting it will go down. Derivatives have become popular as they are relatively unregulated compared to other types of financial instruments, though recent proposals have begun to threaten this.
Derivatives are attacked by pundits for mostly the same reasons as other financial instruments. The amount of money wasted on the financial markets every year, it is said, could end world hunger / cure cancer / satisfy my personal pet cause. It’s nothing more than the usual communist spiel of “Your money would be better spent if I decided what to do with it!”
They are many types of derivatives. It just means that the value of X is derived from the value of Y or the value of a portfolio Y,Z and W.
Nothing wrong with derivatives…problem is…how they have been structured and used.
To make matter’s simple…derivatives is just another tool of “bubbleeconomics”
World’s GDP (not too long ago): 60 trillion
Worlds Derivatives: close to 600 trillion
I dont know about you but this really looks like a huge bubble to me.
A derivative is a bet between two counter-parties (A and B) by which ownership of asset Z changes from A to B or vice versa depending on the outcome of the bet. By their nature, derivatives neither destroy nor create assets – they merely shift their ownership. Example: A and B flip a coin. If A wins, he gets B’s car. If B wins, he get’s A’s car. If both cars’ value is about $10k, this bet created a $10k derivative that can now be added to the $600 trillion derivatives “market” mentioned above.
In the above scenario, the assumption is that both A and B each have (own) a car to transfer to the other when he loses the bet. Person C couldn’t care less how the two cars are allocated between A and B. A problem arises when A and/or B don’t actually have (own) enough assets to cover all potential loses if all their bets went against them – like betting on 3 cars while each only owning one. Enter central banking, fractional reserve banking, and the implicit backing of governments “protecting the economy” and derivatives now allow both A and B to bet on much more than they own, and person C (taxpayer) becomes a sucker player in the A-B bet.
To conclude: in a free market A and B should be able to voluntarily bet on anything they actually own, without affecting person C. Central banking, fractional reserve banking, and governments “protecting the economy” are the means by which A and B can bet on MORE than they own thereby inevitably involving the unsuspecting sucker C (everyone else!) into their bet.
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Not always. Derivatives can be (and are) used to hedge just about any type of risk.
For example, if you are going to be selling 100 oz of copper in a year (say you are in the process of mining it), and you don’t want to worry about the price fluctuating in between now and then. You sell 1 year copper futures and lock in a price that you will sell the gold for. Basically all that happens is that someone who is less risk-averse is just taking on the risk for you. They could be speculating, looking for the price to rise so they can buy it at the cheaper locked-in price and then sell it. Or, they could know that they will need to use the copper in one year, and want to lock in a buying price as well. In that situation no one is gambling, they are just agreeing on a price that they will exchange it in the future.