I believe I understand the underlying concept behind derivatives, but no one in my household or in the realm of academia (where I attend), can give me a straight-forward explanation.
I read several articles on them, but what is the libertarian stance on them?
Thanks.
Seems to me its a voluntary transaction by both parties, no fraud involved, so what's wrong with it ?
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Smiling Dave: Seems to me its a voluntary transaction by both parties, no fraud involved, so what's wrong with it ?
From what I understand, a derivative is just a fancy word meaning contract.
Yes, all that is true. What I meant was that from an Austrian viewpoint, it's not immoral or something that should be outlawed or whatever. If a person fears it, for good reason as you said, let him just not buy one.
Not that I know much about it, but I think you are right and I'll add a detail: It's a contract to buy the rights to collect a loan. That's why it's called a derivative, because it's not the original loan between Mr A and Mr B, but the right to collect a loan already made. So that it is derived from the original loan.
From what I can tell, the derivatives mentioned in the media are instruments that exist through central banking regulations, and so therefore are probably not condoned by the Austrian School. I think the financial crisis last year had its roots in subprime mortgages that were sold as securities on the market. These securities are derivatives of mortgage loans.. or something. It's way easier to understand than it is to explain.
Little excerpt from an article I just read:
In September of 2009, the BIS reported that, “The global market for derivatives rebounded to $426 trillion in the second quarter as risk appetite returned, but the system remains unstable and prone to crises.” The BIS quarterly report said that derivatives rose 16% “mostly due to a surge in futures and options contracts on three-month interest rates.” The Chief Economist of the BIS warned that the derivatives market poses “major systemic risks” in the international financial sector, and that, “The danger is that regulators will again fail to see that big institutions have taken far more exposure than they can handle in shock conditions.” The economist added that, “The use of derivatives by hedge funds and the like can create large, hidden exposures.”
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LvMIenthusiast: I believe I understand the underlying concept behind derivatives, but no one in my household or in the realm of academia (where I attend), can give me a straight-forward explanation. I read several articles on them, but what is the libertarian stance on them? Thanks.
A derivative is a contract whose price is based upon the performance of some other index, financial asset, etc. Take a credit default swap for example. If I buy $300,000 worth of ten year corporate notes with a coupon rate of 6% I may be willing to pay something extra to get it insured. So let's say some insurance company offers to insure my principal (to keep it simple) for $21,000 (these numbers are random). I pay the insurance company or whoever the issuer of the CDS is the $21,000 and if the corporation in question defaults on its debt payments I will still get paid. Obviously if the insured asset(s) are riskier you will have to pay a higher price to insure against a default; this makes things such as CDS very useful in guaging risk. I have an article pinned up on my bulletein board from the WSJ on May 20, 2009 (page B5) which states that from July 9, 2007 to August 3, 2007 the cost of insuring $10 million AAA MBS tranches went from $50,000 up front plus a $9,000 annual premium to $900,000 upfront plus the annual premium! This is a major indicator that there was a huge increase of risk with mortgage backed securities (which were triple AAA rated - the highest possible credit rating). Derivatives are voluntarily bought and sold and hence should not be a problem (if people lose money who invest in them or an institution who invests in them that sucks for them). Funny thing is about a CDS - you don't have to own the underlying security you are buying a CDS for.
- Chris
From what I can tell, the derivatives mentioned in the media are instruments that exist through central banking regulations, and so therefore are probably not condoned by the Austrian School.
I'm not sure what you mean that they "exist" through central bank regulations. The casinos in Vegas exist through laws that make them legal and regulated. However, they should have been legal and unregulated to begin with. Same thing with hospitals, with the stock exchange, with almost anything where money changes hands.
You can't open a hospital or casino or medical practice without a license, and these things are heavily regulated, but the Austrian school isn't anti hospital etc.
Maybe you mean that if Mr A owes me money, what makes it possible for me to say later "Oh by the way, you now owe it to Mr B." I'm not sure about that, but I suppose if it's written into the contract in advance that I can insist he pay anyone I will later stipulate, or who has a paper saying he bought the rights to collect from me, then any Austrian will accept that as a valid binding agreement.
I think the financial crisis last year had its roots in subprime mortgages that were sold as securities on the market. These securities are derivatives of mortgage loans.. or something. It's way easier to understand than it is to explain.
Chris,
Thanks for the informative reply
Smiling Dave:I think the financial crisis last year had its roots in subprime mortgages that were sold as securities on the market. These securities are derivatives of mortgage loans.. or something. It's way easier to understand than it is to explain.
I don't think that securitization is the same as derivatives. If a bank makes $4 million of subprime loans at say 4% interest per annum they are securitized if the bank cuts them and repackages them into say, $500,000 segments and then sells them to other investors. Now these other parties are exposed to these risks; but they own the actual security*, not a contract whose value is tied to the performance of it (which would be a derivative). A derivative may be a MBS swap where if the MBS you buy (or anybody buys since you don't have to own it) defaults you get the money from whoever you bought the swap from.
*This is by no means saying that you can't own the underlying security AND derivative for it; just that a derivative is NOT the underlying security itself.
Chris, once again you have enlightened me [although the lines you quote were from another poster that I forgot to delete].
From what you describe, that no ownership of anything is needed with derivatives, then they are just another way of gambling. If event A happens I win, if not I lose.
So to reply to the OP:
Certainly gambling is a risky thing, but also an ancient and universally recognized economic interaction that an Austrian may personally advise against to his son, but as a pure economist he sees nothing wrong with it.
Thank you for your kind words, Dave.
Thanks guys, you cleared up the murky water for me here.
Derivatives are a lot like firearms.
They generate leverage. They make certain decisions riskier for certain decision makers.
Leverage can be used as a threat or aggression, or to set up traps, sure, but can also be used as proctection against all those abuses and others.
That's the hedging face of the leverage coin.
When leverage tools like firearms and derivatives are widespread, their negative uses generally cancel out.
And that's why governments want to take them away from people.
So the leveraged position they hold is not hedged out.
Well, since it's already been bumped, might as well...
The Social Function of Futures Markets
The Social Function of Credit-Default Swaps
The Social Function of Derivatives Markets [PDF] (haven't read this one, not stamped with libertarian seal of accuracy)
Good to see you back, JJ.
Anyone know why I don't emailed replies to my posts, despite checking the little box?