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Derivatives for Dummies

(Oh, and Journalists)

 

Table of Contents

 

 

Available at the ARTShop

(153 colour pages, soft cover)

 

See also the entire TG2 Series

1 Preface 3

2 The Financial Markets 7
2.1 A Buyer and A Seller: That’s All There Is 7
2.2 The Most Important Law for Businesses: Fiduciary Responsibility 8
2.3 The Participants 9
2.3.1 Lenders/Borrowers – You, Me, Corporations, States/Nations 10
2.3.2 Investors/Hedgers - You, Me, Corporations, States/Nations, and Insurance Companies 11
2.3.3 Prop Traders vs. Investors 12
2.3.4 Dealers/Agents 14
2.4 Traditional Banking – the NIM, and Capital Adequacy 15
2.5 Traditional Investment Banking and Capital Markets 16
2.6 Not so Traditional Banking/Investment Banking/Insurance 16
2.7 Asset Classes 17
2.8 Listed Markets vs. OTC Markets vs. Clearing 17
2.9 Market Size 19

3 Where is the Greed? 20

4 Financial Products Basics 21
4.1 Securities: Loans, and Shares 22
4.2 Derivatives 22
4.3 Structured Products 23

5 Valuation and Creating a Sensible Derivatives Market 24
5.1 The Cost of Delivery 25
5.2 The Fair-Market/Risk-Free/No-Arbitrage Price: Exchange for Physical 25
5.3 Longs Must Equal Shorts, and Hedging 27
5.4 The Fair-Market/Risk-Free/No-Arbitrage Price: Settled for Difference 28
5.5 The Fair-Market/No-Arbitrage Price with Uncertainty and Synthetic Replication 30
5.6 Provisioning and “Non-Market” Derivatives 33
5.7 Fair-Market/No-Arbitrage Valuation and Reality 35
5.8 Expectations vs. Realisation vs. Actual Prices: Supply and Demand 36
5.8.1 Bubbles vs. Artificial Valuation 37
5.8.2 Mark-to-Market vs. Capitalisation vs. Artificial Valuation 38
5.8.3 “Notional” vs. Artificial Valuation 42
5.9 Liquidity: Perhaps the Most Important Element 44

6 Risk/Return and Position Keeping 45
6.1 Society, Uncertainty, and Combat 46
6.2 Resource Required for a Derivatives Business 47
6.3 Speed vs. Crashes and Risk Preference 48
6.4 Risk and Return are (mostly) Commensurate 48
6.5 Speed vs. Crashes: Derivatives and Leveraging 50
6.6 All Investments are “Bets” by Definition 50
6.7 Trading Discipline and Business Model 51
6.7.1 Market Making 52
6.7.2 Investing/Prop Trading 53
6.7.3 Rogue Trader and the Myth of Plausible Deniability 54
6.7.4 Rogue Governments and the “Wag the Dog” 57
6.8 Position Keeping vs. Risk Management 59
6.9 Risk, Position, and P&L Reporting 60
6.9.1 Regulator Reporting 60
6.9.2 Who Generates the Reports? 61

7 Derivatives – Insurance Or Betting? 63
7.1 All Insurance Policies are Derivatives 63
7.2 Hit by an Asteroid. No, wait, it was the US Congress! 64
7.3 OTC Derivatives vs. Listed/Exchange Traded Derivatives 67
7.4 In Search of Glass-Steagall – Systemic Risk and Bail-outs 69
7.5 Replication vs. Provisioning vs. Capital Adequacy 71
7.6 Auto Insurance and Default Swaps (the basics are easier than you think) 72
7.6.1 Vanilla Swaps 72
7.6.2 Vanilla Swaps – Counterparty/Default Risk and Swap Spreads 74
7.6.3 Reference Rates and LIBOR Swaps 75
7.6.4 Asset Swaps 76
7.6.5 Default Swaps 77
7.6.6 There is Nothing “Evil” in Default Swaps 78
7.6.7 Default Swaps and Capital Adequacy “Naughtiness” and GSA 79
7.6.8 Default Swaps and Wall Street: Politicians “Wag the Dog” 80
7.7 Mortgages: The Most Complicated Derivatives are Sold to the Least Sophisticated 81
7.7.1 Virtually All Mortgages are Derivatives/Structured Products 81
7.8 Mortgage Backed Securities (MBS’s) and Tranching 84
7.9 Collateralised Debt Obligations (CDO’s) and Default Tranching 86
7.10 Too Big To Fail: Meaningless Compared to Fannie & Freddie/US Government 88
7.11 The Role of Governments (In Derivatives), If Any 89
7.12 Derivatives and Profitability 90
7.13 Hedging is “Negative Betting”: Shorting and Earthquake insurance are good things. 90

8 Regulations And Regulators 94
8.1 Derivatives Markets are Unregulated – A Complete Lie 94
8.2 The Civil Courts, Contract Law, and Criminal Proceedings 94
8.3 Who is Regulated? 95
8.4 Who are the Regulators: Federal/Sovereign vs. Industry? 95
8.5 Compliance Departments 96
8.6 Risk Management Departments 96
8.7 Mid- and Back-Offices 97
8.8 Accreditation 97
8.9 Client Relationship Regulations and Fiduciary Responsibility 97
8.10 Instrument and Business Type Regulations 98
8.11 Operating Regulations 98
8.12 Capital Adequacy and Related Regulations 98
8.13 OTC Market Regulation vs. Listed Market Regulation 100
8.14 Exuberant Euphoria vs. Hysteria vs. Regulations and “The Law of Unintended Consequences” 102
8.15 Bad Regulations: The Ghost of Smoot–Hawley, and The Law of Unintended Consequences 103
8.16 US Becomes Pre-Eminent Economic Power with Removal of Bad Regulations 103
8.17 US Becomes Second Class Nation Due To Bad Regulations and Political Trickery 104
8.18 World Economy Collapses 104

9 The Melt-Down of 2008 – The Single Biggest Financial Loss in Human History – Caused by Congress 106
9.1 Wall Street Bashing – A Political Trick 106
9.2 The Single Biggest Factor – The Congress of the United States (Not Wall Street) 107
9.2.1 Repeal of the GSA 107
9.2.2 Abusing the GSE’s for Political Purposes and “The American Dream” 108
9.2.3 US Congress Creates the Mortgage Bubble and Toxic Assets 109
9.2.4 US Congress Repeatedly Warned of GSE/Mortgage Risk 111
9.2.5 US Congress Allows The GSE’s to Further Ruin the Economy, even After the Clear Signs of Problems in 2006/2007. 112
9.3 What the Blazes are GSE’s? 113
9.3.1 The Best Intentions Gone (Horribly) Wrong 113
9.4 The Special Case of the US Mortgage (Secondary) Market 115
9.5 An Overview of US Mortgage and Related Data 117
9.5.1 The Core Market 117
9.5.2 The Impact of Interest Rates & GSE Massive Over Supply: Anatomy of the Bubble 120
9.5.3 The Mortgage Bubble and the Creation of the “Sub-Prime Bomb” 122
9.5.4 Fannie & Freddie (The Problem is Washington and Virginia ... not Wall Street) 123
9.5.5 Fannie & Freddie Disintegrate – Taking (at least) 1.5 Trillion 124
9.6 The Federal Reserve System – Cover-Up the Largest Financial Loss in Modern History … Caused by the US Congress 126
9.6.1 What is the Fed, What do they do (or supposed to do)? 126
9.6.2 What are “Open Market Operations”? 126
9.6.3 How can the government spend 1.5 Trillion without Congressional Approval 128
9.6.4 Bail-Out of the Auto Companies 130
9.7 The “Bail-Out” Was (mostly) NOT for the Banks 131
9.7.1 FDIC, TARP, HERA, and the Fed 132
9.7.2 Obama Administration’s Abuses of TARP 134
9.8 The Role of Derivatives 134
9.9 Comparison to Other Disasters 136
9.9.1 The Great Depression of 1929 136
9.9.2 The S&L Crisis 1978 - 1989: “Its Déjà vu All Over Again” 138

10 Derivatives, Bonuses, and Democracy 139

11 References 143

12 Index 144

 

Available at the ARTShop

(153 colour pages, soft cover)

 

See also the entire TG2 Series

 

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Last modified: July 25, 2011