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Derivative (finance) - 101 course
Its quite obvious that most people don't understand derivatives and derivatives underlie all the current financial problems.

I first refer people to the Wikipedia link that explains them in brief. Click the article heading for the link.

now slide down to this point:

OTC and exchange-traded

Broadly speaking there are two distinct groups of derivative contracts, which are distinguished by the way they are traded in market:

* 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]. Yes - that is not a typo - many many times the GNP 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.

* Exchange-traded derivatives (ETD) are those derivatives products that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange acts as an intermediary to all related transactions, and takes Initial margin from both sides of the trade to act as a guarantee. The world's largest[2] derivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products), and CME Group (made up of the 2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade and the 2008 acquisition of the New York Mercantile Exchange). According to BIS, the combined turnover in the world's derivatives exchanges totaled USD 344 trillion during Q4 2005. 344 trillion in one quater! Some types of derivative instruments also may trade on traditional exchanges. For instance, hybrid instruments such as convertible bonds and/or convertible preferred may be listed on stock or bond exchanges. Also, warrants (or "rights") may be listed on equity exchanges. Performance Rights, Cash xPRTs and various other instruments that essentially consist of a complex set of options bundled into a simple package are routinely listed on equity exchanges. Like other derivatives, these publicly traded derivatives provide investors access to risk/reward and volatility characteristics that, while related to an underlying commodity, nonetheless are distinctive.

Common derivative contract types

There are three major classes of derivatives:

1. Futures/Forwards, which are contracts to buy or sell an asset at a specified future date.
2. Optionals, which are contracts that give a holder the right to buy or sell an asset at a specified future date.
3. Swappings, where the two parties agree to exchange cash flows or returns.

Look at the table of common examples and then at the following:


Other examples of underlying exchangeables are:

* Economic derivatives that pay off according to economic reports ([1]) as measured and reported by national statistical agencies
* Energy derivatives that pay off according to a wide variety of indexed energy prices. Usually classified as either physical or financial, where physical means the contract includes actual delivery of the underlying energy commodity (oil, gas, power, etc.)
* Commodities
* Freight derivatives
* Inflation derivatives
* Insurance derivatives[citation needed]
* Weather derivatives
Yes weather derivatives - Gustav and Ike?
* Credit derivatives
* Property derivatives


Even a Global Warming Derivative
Global Warming Index
Investment bank UBS is trying to change weather investing by launching the first Global Warming Index (GWI), which provides a simple way to take a view on a wide range of weather variables. While initially linked to the temperature of several US cities, there are plans to add European and Asian ones soon. In fact, as UBS notes, there is no limit in principle to the number of cities to be included as references. In this sense, the UBS index would truly capture global phenomena in one stroke.

Thanks to this pioneering development, it is now possible to bet on whether Global Warming is true or false. If you believe the direst predictions will hold true and a persistent upward trend in global (or, at least for now, US) temperatures will become the norm, you would buy the Index (which goes up with the underlying temperature). If you think Mr Gore an alarmist sensationalist, you would sell the Index.

In common with equity, foreign exchange or interest rate underlyings, it is possible to devise structured products based on the GWI. For instance, rather than park money in a low-yielding savings account, an investor could instead enter into a weather-related guaranteed investment or a weather-related note, where returns would depend on the average quarterly performance of the Index. In essence, the warmer the globe gets (as measured by the GWI) the higher the return.

Most interesting are the opportunities to engineer basket, or diversified, structures around the GWI. In these exotic deals, the investor's return would depend directly on the (most likely, purely coincidental rather than direct) correlation between weather and one, two, or more different asset classes.

GWI-based basket trades could help investors in traditional assets to diversify (hedge) their positions via the addition of a non-correlated new variable. Given how closely correlated markets can be from time to time, it may not be a bad idea to include some weather in an old-fashioned menu. If anything, the GWI could be seen as a cheaper (not to mention more exciting) alternative to protecting returns through the use of same-family derivatives (such as equity options or currency forwards).

Now look further in the link. The Criticisms, the arbitrage-free pricing, the Benefits, the Leverage of an economy's debt.

Now take a look at this scaremongering report that ends up making sense.

NO To The Paulson-Bernanke Derivatives Scam Bailout

the NO to Bailout article ends with this solution:

CLEARING THE DECKS FOR WORLD ECONOMIC RECOVERY

It is time to forget about paper and the price of paper, and to concentrate on production securing the tangible physical commodities and hard commodity production which are necessary for human life and civilization. It is impossible to prop up financial values in a panic, and it is foolish to try. To secure a decent future, we must now enact the following measures. Any of these points, all of which seek to defend the general welfare and the public interest, can and should be used as killer amendments to be attached to the current bailout monstrosity as a means of bringing it down.

Stop all foreclosures on homes, farms, businesses, factories, mines, transport systems, for a period of at least five years or for the duration of the present world economic depression, whichever takes longer. If you throw a family out of their home or shut down a family farm, taxicab company, trucking firm, ferry, airline, railroad, or factory of any kind because of debt, you will be on your way to Leavenworth. All politicians now say that we have to keep families in their homes. Excellent! A uniform federal law with real teeth is the way to do it.

Seize bankrupt banks and financial institutions. Put them through Chapter XI bankruptcy, and cancel the hopelessly unpayable parts of their debts, starting with their derivatives book.
Wipe out all derivatives, whether exchange traded or counterparty, without compensation. They have always been illegal. They are now a threat to all of our lives. Not one penny of public money must go to buy derivatives.

Securities transfer tax or Tobin tax on all financial transactions, including stocks, bonds, foreign exchange, etc. This is a sales tax on finance oligarchs who need to start paying their fair share. This will take the life out of the booze for many speculators.
Stop oil, food and commodity speculation with comprehensive re- regulation including position limits, 50 to 100% margin requirements depending on market conditions, and by distinguishing between legitimate hedgers and predatory speculators.

No tax increases on households. Surtax for foundations like the Ford, Rockefeller, Carnegie, Annenberg, and Gates Foundations, who use their funds not for charity but for subversion and divide and conquer social engineering to divide and weaken the American people in defense of the financier interest.

Restore business confidence and credit with new credit issue through the nationalized Federal Reserve, operating under the legal auspices of the US Treasury. Use credit as a public utility. Provide cheap, long-term credit for productive purposes only, not parasitical speculation or financial services.

Institute an absolute guarantee for Social Security, Medicare, Medicaid, Head Start, WIC, food stamps, unemployment insurance, and the other remaining elements of the social safety net. No “entitlement reform” under any circumstances. Austerity for bankers, not people. Use the proceeds from the Securities Transfer Tax to replenish the Social Security Trust Fund and preserve the other vital programs through the end of the twenty-first century.

Using New Deal methods, it is possible to stop a depression cold in a single day. We did it before, and we can do it again. Only 28% of the American people now support the monstrous derivatives bailout, with 37% opposed and 35% unsure, according to Rasmussen on Sept. 22. This is an issue powerful enough to crystallize the current party re-alignment in the same way that slavery in the territories did in 1860, or the last depression did in 1932. Within a month, the current empty husks of the gutted Democratic and Republican Parties could collapse, and be replaced by the pro-Wall Street Bailout Party led by Obama and his phalanx of rich elitists and Malthusian fanatics from both parties, and the pro-middle class and pro-worker Anti-Bailout Party with support from right-wing Republicans, libertarians, and working class Democrats. Who will have the brains and guts need to assert leadership over the Anti- Bailout Party? Will it be McCain? Or Hillary Clinton? Or someone else? We will soon find out.

I am not advocating or saying anything other than something smells rotten in the US and derivatives are deeply involved. The explanations by Paulson, Bernake and Bush are too simplex and likely complete fabrications to get us to agree to this for some reason likely unrelated to the mortgages. Why? If it was related to them the solution suggested by the Republican House would be jumped on as the obviously cheaper and more rational solution. It is being fought tooth and nail so something else needs the money...

Posted by: 3dc 2008-09-26
http://www.rantburg.com/poparticle.php?ID=251087