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Derivatives for Dummies

(Oh, and Journalists)

3rd Edition v3b (May 2018)

 

Table of Contents

 

 

Available at the ARTShop

(263 colour pages, soft cover)

 

See also the entire TG2 Series


1 Preface_____________________________________________________________________3
1.1 CAVEAT: Ideology - The "What it is" vs. The "What you may wish it would be"______4
1.2 Additional Summary information as of 3rd Edition Ver b) ________________________5
1.3 The Story So Far _________________________________________________________6
 

2 The (Really) Big Picture: There are crashes and there are CRASHES __________________15
 

3 The Financial Markets________________________________________________________21
3.1 A Buyer and A Seller: That’s All There Is ____________________________________22
3.2 Liquidity ______________________________________________________________24
3.3 The Most Important Law for Businesses: Fiduciary Responsibility ________________24
3.4 The Participants_________________________________________________________26
3.4.1 Lenders/Borrowers – You, Me, Corporations, States/Nations _________________27
3.4.2 Investors/Hedgers - You, Me, Corporations, States/Nations, and Insurance
Companies_________________________________________________________________28
3.4.3 Prop Traders vs. Investors_____________________________________________30
3.4.4 Dealers/Agents _____________________________________________________32
3.5 Traditional Banking – the NIM, and Capital Adequacy __________________________33
3.6 Traditional Investment Banking and Capital Markets ___________________________35
3.7 Not so Traditional Banking/Investment Banking/Insurance_______________________36
3.8 Asset Classes ___________________________________________________________36
3.9 Listed Markets vs. OTC Markets vs. Clearing _________________________________37
3.10 Market Size ____________________________________________________________39
3.11 Bid/Offer Spread ________________________________________________________41
 

4 Where is the Greed? _________________________________________________________43
 

5 Financial Products Basics _____________________________________________________45
5.1 Securities: Loans, and Shares ______________________________________________46
5.2 Derivatives ____________________________________________________________47
5.3 Structured Products ______________________________________________________48
 

6 Valuation: Creating a Sensible Derivatives Market _________________________________49
6.1 The Cost of Delivery_____________________________________________________50
6.2 The Fair-Market/Risk-Free/No-Arbitrage Price: Exchange for Physical _____________50
6.3 Longs Must Equal Shorts, and Hedging ______________________________________53
6.4 The Fair-Market/Risk-Free/No-Arbitrage Price: Settled for Difference______________55
6.5 The Fair-Market/No-Arbitrage Price with Uncertainty and Synthetic Replication _____57
6.6 Provisioning and “Non-Market” Derivatives __________________________________62
6.7 Fair-Market/No-Arbitrage Valuation and Reality_______________________________65
6.8 Expectations vs. Realisation vs. Actual Prices: Supply and Demand________________67
6.8.1 Bubbles vs. Artificial Valuation ________________________________________68
6.8.2 Mark-to-Market vs. Capitalisation vs. Artificial Valuation ___________________70
6.8.3 “Notional” vs. Artificial Valuation ______________________________________74
6.9 Liquidity: Perhaps the Most Important Element ________________________________77
 

7 Risk/Return and Position Keeping ______________________________________________79
7.1 Society, Uncertainty, and Combat___________________________________________81
7.2 Resource Required for a Derivatives Business _________________________________83
7.3 Speed vs. Crashes and Risk Preference_______________________________________84
7.4 Risk and Return are (mostly) Commensurate __________________________________84
7.5 Speed vs. Crashes: Derivatives and Leveraging ________________________________86
7.6 All Investments are “Bets” by Definition _____________________________________87
7.7 Risk/Return vs. Investing/Betting for Retirement_______________________________88
7.8 Trading Discipline and Business Model ______________________________________89
7.8.1 Market Making _____________________________________________________90
7.8.2 Investing/Prop Trading _______________________________________________92
7.8.3 Rogue Trader and the Myth of Plausible Deniability ________________________93
7.8.4 Rogue Governments and the “Wag the Dog” ______________________________97
7.9 Position Keeping vs. Risk Management ______________________________________99
7.10 Risk, Position, and P&L Reporting_________________________________________100
7.10.1 Regulator Reporting ________________________________________________101
7.10.2 Who Generates the Reports? __________________________________________102
 

8 Derivatives – Insurance Or Betting? ____________________________________________105
8.1 All Insurance Policies are Derivatives ______________________________________105
8.2 Hit by an Asteroid. No, wait, it was the US Congress! _________________________106
8.3 OTC Derivatives vs. Listed/Exchange Traded Derivatives ______________________111
8.4 In Search of Glass-Steagall – Systemic Risk and Bail-outs ______________________113
8.5 Replication vs. Provisioning vs. Capital Adequacy ____________________________116
8.6 Auto Insurance and Default Swaps (the basics are easier than you think) ___________118
8.6.1 Vanilla Swaps _____________________________________________________118
8.6.2 Vanilla Swaps – Counterparty/Default Risk and Swap Spreads_______________121
8.6.3 Reference Rates and LIBOR Swaps ____________________________________122
8.6.4 Asset Swaps_______________________________________________________123
8.6.5 Default Swaps _____________________________________________________126
8.6.6 There is Nothing “Evil” in Default Swaps _______________________________127
8.6.7 Default Swaps and Capital Adequacy “Naughtiness” and GSA_______________128
8.6.8 Default Swaps and Wall Street: Politicians “Wag the Dog” _________________130
8.7 Mortgages: The Most Complicated Derivatives are Sold to the Least Sophisticated___131
8.7.1 Virtually All Mortgages are Derivatives/Structured Products ________________131
8.8 Mortgage Backed Securities (MBS’s) and Tranching __________________________135
8.9 Collateralised Debt Obligations (CDO’s) and Default Tranching _________________139
8.10 Too Big To Fail: Meaningless Compared to Fannie & Freddie/US Government _____141
8.11 The Role of Governments (In Derivatives), If Any ____________________________143
8.12 Derivatives and Profitability ______________________________________________144
8.13 Hedging is “Negative Betting”: Shorting and Earthquake insurance are good things.__145
 

9 Regulations And Regulators __________________________________________________149
9.1 Derivatives Markets are Unregulated – A Complete Lie ________________________149
9.2 The Civil Courts, Contract Law, and Criminal Proceedings______________________150
9.3 Who is Regulated? _____________________________________________________151
9.4 Who are the Regulators: Federal/Sovereign vs. Industry? _______________________151
9.5 Compliance Departments ________________________________________________152
9.6 Risk Management Departments ___________________________________________152
9.7 Mid- and Back-Offices __________________________________________________153
9.8 Accreditation __________________________________________________________154
9.9 Client Relationship Regulations and Fiduciary Responsibility____________________154
9.10 Instrument and Business Type Regulations __________________________________155
9.11 Operating Regulations___________________________________________________155
9.12 Capital Adequacy and Related Regulations __________________________________156
9.13 OTC Market Regulation vs. Listed Market Regulation _________________________157
9.14 Exuberant Euphoria vs. Hysteria vs. Regulations and “The Law of Unintended
Consequences” ______________________________________________________________162
9.15 Bad Regulations: The Ghost of Smoot–Hawley, and The Law of Unintended
Consequences _______________________________________________________________163
9.16 US Becomes Pre-Eminent Economic Power with Removal of Bad Regulations ______163
9.17 US Becomes Second Class Nation Due To Bad Regulations and Political Trickery ___164
9.18 World Economy Collapses _______________________________________________165
 

10 The Melt-Down of 2008 – The Single Biggest Financial Loss in Human History – Caused
by Congress
___________________________________________________________________167
10.1 "Follow the Money" Pulitzer Prize or Preposterous? ___________________________169
10.2 Wall Street Bashing – A Political Trick _____________________________________170
10.3 The Single Biggest Factor – The Congress of the United States (Not Wall Street) ____171
10.3.1 Repeal of the GSA__________________________________________________171
10.3.2 Abusing the GSE’s for Political Purposes and “The American Dream” ________172
10.3.3 US Congress Creates the Mortgage Bubble and Toxic Assets ________________173
10.3.4 US Congress Repeatedly Warned of GSE/Mortgage Risk ___________________177
10.3.5 US Congress Allows The GSE’s to Further Ruin the Economy, even After the Clear
Signs of Problems in 2006/2007. ______________________________________________178
10.4 What the Blazes are GSE’s? ______________________________________________180
10.4.1 The Best Intentions Gone (Horribly) Wrong _____________________________180
10.5 The Special Case of the US Mortgage (Secondary) Market ______________________182
10.6 An Overview of US Mortgage and Related Data ______________________________185
10.6.1 The Core Market ___________________________________________________185
10.6.2 The Impact of Interest Rates & GSE Massive Over Supply: Anatomy of the Bubble
190
10.6.3 The Mortgage Bubble and the Creation of the “Sub-Prime Bomb” ____________193
10.6.4 Fannie & Freddie (The Problem is Washington and Virginia ... not Wall Street, not
even New York) ___________________________________________________________196
10.6.5 Fannie et al Disintegrate – Lose About 5 Trillion__________________________198
10.7 The Federal Reserve System – Cover-Up the Largest Financial Loss in Modern History
… Caused by the US Congress __________________________________________________202
10.7.1 What is the Fed, What do they do (or supposed to do)? _____________________202
10.7.2 What are “Open Market Operations”? __________________________________203
10.7.3 How can the Fed print/spend Trillions without Congressional Approval________205
10.7.4 The Fed: The Government Bailing-Out Itself with Many Trillions of Printed Money
208
10.8 The (Congressional) “Bail-Out” Was (mostly) NOT for the Banks ________________212
10.8.1 HERA - Scarier than Wes Craven? _____________________________________212
10.8.2 FDIC and TARP ___________________________________________________216
10.8.3 Obama Administration’s Abuses of TARP_______________________________219
10.8.4 Bail-Out of the Auto Companies_______________________________________220
10.9 The Role of Derivatives _________________________________________________223
10.10 Comparison to Other Disasters __________________________________________225
10.10.1 The Great Depression of 1929 ______________________________________225
10.10.2 The S&L Crisis 1978 - 1989: “Its Déjà vu All Over Again” _______________227
 

11 Derivatives, Bonuses, and Democracy ________________________________________229
 

12 Will the Bail-Outs Cause the Next Catastrophe? ________________________________237
 

13 References ______________________________________________________________241
 

14 Appendices _____________________________________________________________243
 

14.1 How The Fed's Buying of T-Bonds is an "Implicit" Bail-Out of GSE's_____________243
14.1.1 First, just a little Present Value Theory (PVT) ____________________________246
14.1.2 (Super Simple) MBS Toxic Assets _____________________________________249
14.1.3 T-Bonds are an "Indirect" Bail-Out of the GSE's __________________________250
 

14.2 Finance vs. Economics: When Is Economics Worse Than Useless? _______________251
14.2.1 Buy the Rumour, Sell the Fact, and Many Others _________________________251
14.2.2 Other aspects of "opposite land" _______________________________________254
14.2.3 Economics Indicators vs. P&L and more "Opposite Land" __________________254
14.2.4 Trade Idea Generation_______________________________________________256
14.2.5 You had to have gone to university to say something that stupid______________256
14.2.6 Skin in the game ... , and Agenda ______________________________________258
 

Index ________________________________________________________________________261



 

Available at the ARTShop

(263 colour pages, soft cover)

 

See also the entire TG2 Series

 

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