There is a meme around the “left” that the banking industry, insurance and derivates (like futures contracts) just “skim” profits and don’t really do anything but add extra costs to the economy. Here is an example to help explain why killing the derivatives business would be a really bad thing.
So let me construct a hypothetical:
The King of Fredonia wants to buy a Boeing 787 Dreamliner The price for the plane is around $200 million
Right now, the Fredonian Freebuck trades against the US dollar at a rate of $1 = 10 Freebucks…. so the airplane is going to cost the king of Fredonia two billion freebucks ($200 million x 10) if he could buy it today – the 2 billion freebucks are sitting in the bank of Fredonia – profits from selling cans of gourmet duck soup, primarily to France.
Boeing currently is making only two 787 dreamliners a month, and hopes to get production up to 10 a month – there are currently 800 orders already waiting for delivery. If the king of Fredonia wants a 787, he can plan on having to wait at least 80 months to take delivery (more than 6 years)
Boeing does business in dollars, not Freebucks. Six years from now, Boeing expects the Kingdom of Fredonia to show up with a check for $$200 million to take delivery of the plane.
What happens if the Freebuck starts to lose value because the factory workers at the duck soup factory go on strike demanding 10 weeks a year of vacation? If in 6 years, the Freebuck falls to needing 50 freebucks to buy $1, the airplane will cost 5 billion freebucks, which the kingdom may not be able to come up with.
One way to handle that is the King of Fredonia could go out and buy $200 million in dollars today, and stuff the US dollars in the Bank of Fredonia in a special account. Doing that has a few problems – that money is now locked up and can’t be used for 6 years – the money isn’t going to be spent for 6 years, but depletes the government treasury today. The Bank of Fredonia is owned by Harpo Marx, the King’s second cousin’s wife’s father in law. The Bank of Fredonia might fail when Harpo goes to Las Vegas and puts $200 million on 42 on the roulette wheel and loses.
Enter the Currency Futures contract… instead of converting the Freebucks to Dollars today, a large reliable international bank that is “too big to fail” whose slogan is “We do God’s work for Him” offers Fredonia a deal. We agree that 6 years from now, when you hand us 2 billion Freebucks, we’ll pay Boeing $200 million for your plane. Since we’re assuming the risk that the Freebuck might lose value, we would like an upfront fee of an extra 200 million Freebucks. We’ll be here six years from now to pay this off – God says so.
With the futures contract in hand, the Kingdom of Fredonia feels safe that they can order the plane now and not have to wait until there is nobody waiting in line and they can buy the plane for cash. God’s Bank is guaranteeing the $200 million will be there when the time comes.
The Order Taking Department at Boeing receives an order from the Kingdon of Fredonia along with proof they will have the US dollars to pay for the plane. The CEO of Boeing now sees on his Blackberry there are 801 orders backed up for 787s – he’s spending most of his time on the phone trying to keep the customers who are in line happy while they wait and dealing with the accountants trying to guess what the future profits will be. Something must be done.
Because so many companies and governments have all these orders and customers are started to threaten to buy their planes from China, Boeing takes their 801 confirmed orders to their bankers and says “See, we’re good for it – we need more money so we can build a new factory in South Carolina so we can build more planes a month and cut down this backlog and make more money faster”.
Because Boeing has all those solid orders, God’s Bank lends them the money to build the new factory, people are hired to build the factory and then build the plane parts faster – the price of Boeing’s stock goes up, wealth is created – people’s 401(k) accounts get bigger.
Now you might be asking…. buy what if Fredonia discovers oil under the castle and suddenly the Bank of Fredonia is overflowing with dollars and it now takes $10 to buy one Freebuck? The plane in six years could have been bought for only in cash for only 20 million freebucks – not 2 billion. The decision to buy a currency futures contract then looks like a really bone-headed decision, especially the fee that was paid to arrange the deal.
But nobody knows the future – derivatives markets offer to let you get rid of risk, but paying a premium to someone who is willing to take that risk – it’s not unlike insurance. The seller of derivatives who does the best guess at predicting the future (or controlling the future by killing the king of Fredonia) wins. The company that loads up with bets on Greek and Italian bonds loses.
I honestly didn’t know about the UAE ordering a huge fleet of planes from Boeing for $18 billion when I wrote this 🙂
Didn’t UAE cancel several orders (for planes) due to the downturn?
Great explanation.. I had no idea how derivatives worked before this and had always been curious.
Nice Hitchhiker’s Guide reference too. I almost missed it
I don’t take issue with the ‘derivatives’ market per se… you want risk? Have at it.
My problem is how it has morphed into a globalized Mob casino, where the owners and big ‘players’ (via markers or 1% margins) are protected from any -real- losses.
Members of Congress can participate in insider trading that would land me in jail. Big boys get insiders to downgrade assets, Bernanke prints up currency, and his cohorts swoop in for pennies on the dollar. Then there’s Timmy, Paulson, Pelosi and friends.
Want to place puts/calls, or bet on derivatives, mortgage CDS, or exotic investment ‘instruments’? Fine, but don’t expect bailouts to the tune of Trillion$ (or $1 for that matter) when someone pulls a card out from the foundation of the big card-house.
The EU apparently just passed a rule preventing “Naked” CDS transactions, which makes sense.
I’ve used this analogy before, but I think it makes sense of just what is going on…
Bob and Tom agree to play a hand of 7 card draw poker. They bet $10 on the outcome.
Mary and Sally hear that Bob and Tom have this bet. Mary bets Sally $100 that Bob will win the hand and win the $10.
Phil and Angela hear about Mary and Sally’s bet…. Phil bets Angela $1000 that Mary will win her bet.
So if Bob wins, he wins $10, Mary wins $100 and Phil wins $1000. If Bob loses, he loses $10, Mary loses $100 and Phil loses $1000
So with those bets in place, Angela pulls Bob aside and says “I’ll give you $50 if you just fold your hand without looking at the cards”
Bob accepts the offer and “loses” his hand. Bob loses the $10, but has the $50 from Angela, so he is $40 ahead. Tom wins $10, Sally gets her $100 from Mary and Angela gets her $1000 from Phil, so she winds up ahead $950 ($1000 minus the $50 she paid Bob to lose on purpose)
Phil figures out he has been cheated. So Bob & Tom repeat their bet. Angela pays her $50 to Bob to lose, but this time phil approaches Tom and offers to pay him $100 if he’ll fold his hand before Phil.
“Naked” CDSs are essentially this game. People who don’t actually have their money in the game start betting on the outcome (see: Leverage)… and then even bigger money is gambled on that outcome. People who had nothing at risk if Greece Defaults because they don’t own any Greek Debt start betting on the outcome of someone else’s problem. This is your basic moral hazard – life insurance companies don’t let you take out a policy on the death of another person because you then have an incentive to cause the death of that person.
However the flaw here to this ban is that if only people who own Greek Bonds can buy CDS to protect themselves, in the future Greece may find it harder and/or more expensive to sell their bonds. If a buyer of a Greek bond protected by a CDS wants to sell it later, they’ll either have to sell the bond plus the CDS to the buyer as a package. If the bond owner sells the bond, if they are allowed to keep the CDS, that defeats the purpose of this rule. If the 2nd buyer wants to buy both the Bond and the CDS, things get messy.
I’ll see your bond, and raise you a Boeing: 😉
UAE orders planes from Boeing, biz is good
Arab Spring arrives and the future gets dicey
UAE cancels Boeing orders ‘due to economy’
Obama/NLRB strong-arms Boeing in SC
Obama ‘offers’ combat troops to Kuwait
UAE et-al have visions of an ‘Arab Fall’
UAE orders 777’s to boost their luck
Biz is looking up again at Boeing…
Needless to say, I’m cynical about the players
Late to the game, but I’m chiming in just to thank you, Art, for the explanation of “derivative.” Well done.
Well, that’s just one example. There are a growing variety of derivatives that may have little social value.
Another type of futures contract around for at least 100 years is the futures contract for agricultural products. Kellogg’s would like to know what it will have to pay for corn next year and not get yanked around by high prices if there is a bad crop. So they lock in their prices using futures.
The corn farmer needs to borrow money to plant seeds in the spring, not knowing if the corn prices will go up or down. Banks are hesitant to lend that money and take in the risk that corn prices might fall – so the bank may only agree to lend the money if the farmer “locks in” his harvest price before he plants in the spring – for at least part of his crop.
Corn flakes now have a predictable price, and more corn will be grown because the farmer and his banker aren’t going to be out of business if there is a record harvest and prices plummet below what it cost to plant the crop.
In New England, a lot of people still heat with oil. Typically, each fall oil companies will offer to “lock in” the price of oil for the entire winter at a price a little higher than today’s price. Houses don’t typically have a tank big enough to hold an entire season’s fuel, and even if they did, you can’t know how cold the winter will be.
So you can just buy as you go at the current (“spot”) price – the price may go up, it may go down…. Or you can pay a little extra to limit your risk of the prices going up. Most people think that’s a reasonable thing for an oil company to offer, but it us exactly the same idea as a futures contract – which is how the oil dealer is able to offer that option.