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.\u00a0\u00a0\u00a0\u00a0 Here is an example to help explain why killing the derivatives business would be a really bad thing.<\/p>\n
So let me construct a hypothetical:<\/p>\n
The King of Fredonia wants to buy a Boeing 787 Dreamliner\u00a0\u00a0 The price for the plane is around $200 million<\/a><\/p>\n Right now, the Fredonian Freebuck trades against the US dollar at a rate of $1 = 10 Freebucks….\u00a0\u00a0 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.<\/p>\n 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.\u00a0\u00a0 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)<\/p>\n Boeing does business in dollars, not Freebucks.\u00a0\u00a0 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.<\/p>\n 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?\u00a0\u00a0 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.<\/p>\n 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.\u00a0\u00a0\u00a0 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.\u00a0\u00a0 The Bank of Fredonia is owned by Harpo Marx, the King’s second cousin’s wife’s father in law.\u00a0\u00a0\u00a0 The Bank of Fredonia might fail when Harpo goes to Las Vegas and puts $200 million on 42 on the roulette wheel and loses.<\/p>\n Enter the Currency Futures contract…\u00a0 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. \u00a0\u00a0 We agree that 6 years from now, when you hand us 2 billion Freebucks, we’ll pay Boeing $200 million for your plane. \u00a0 Since we’re assuming the risk that the Freebuck might lose value, we would like an upfront fee of an extra 200 million Freebucks. \u00a0 We’ll be here six years from now to pay this off – God says so.<\/p>\n 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. \u00a0 God’s Bank is guaranteeing the $200 million will be there when the time comes.<\/p>\n 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. \u00a0 The CEO of Boeing now sees on his Blackberry there are 801 orders backed up for 787s – he’s spending most of\u00a0 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.\u00a0 Something must be done.<\/p>\n 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”.<\/p>\n 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.<\/p>\n Now you might be asking….\u00a0 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? \u00a0 The plane in six years could have been bought for only in cash for only 20 million freebucks – not 2 billion. \u00a0 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.<\/p>\n 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. \u00a0\u00a0 The seller of derivatives who does the best guess at predicting the future (or controlling the future by killing the king of Fredonia) wins. \u00a0 The company that loads up with bets on Greek and Italian bonds loses.<\/p>\n","protected":false},"excerpt":{"rendered":" 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.\u00a0\u00a0\u00a0\u00a0 Here is an example to help explain why … Continue reading