On 28 Apr, 23:13, MJB <[email protected]> wrote: > The social benefit of derivatives is not "risk" and "gambling," it is > the opposite. Where derivatives are at their most useful is when they > are being used to reduce risk. > > For example, the oldest type of derivatives are commodity derivatives. > Let's say you're a company that makes orange juice. The main cost you > have is the price of oranges. However, you are not in the business of > growing oranges - you are in the business of making orange juice. > Therefore, the profit you make should depend on how well you are > making orange juice, i.e., how well you are catering to the tastes of > the public in making a smooth-tasting juice, how well you are > marketing your product, how well you are dealing with competitors by > finding market niches where they aren't, and by acquiring them if that > creates synergies. > > But instead of depending on all this, your profit depends in large > part on the price of oranges. In years when the weather was terrible > and oranges are scarce and oranges are expensive, you're not making a > lot, and in years when oranges are cheap, you're making much more > profit. But, as we said, you're not in the orange business, you're in > the orange juice business. You simply don't want your business profit > to depend on the price of oranges. So what do you do? > > Well, as we said, without any derivatives, you're making much more > money when oranges are cheap, and much less money when oranges are > expensive. So what you should do is invest in orange futures. This > way, when the price of oranges goes up, your orange-juice making > business makes less money (because the cost of its input has risen), > but the value of your orange futures (a derivative that you bought) > goes up by an offsetting amount. > > So what's the point of this? Well, all of a sudden, your business > model, which previously was very dependent on the price of oranges, > now has nothing to do with the price of oranges at all. When the price > of oranges rises, your business profit falls, but your orange futures > rise by an offsetting amount. So now your business profits have to do > with how well you do your job, that is, how well you run the orange > juice market, and they no longer have to do with something outside > your control, i.e., the price of oranges. > > That is what derivatives do. They allow for hedging (which means, the > reduction of risk), so that things that are irrelevant to you won't > affect your profit. A mom-and-pop jewelry store has its business > suffer when the price of gold rises, so it should invest in gold > derivatives. There are many, many examples. > > While some derivatives are closer to the gambling line than others, > financial institutions pay lawyers lots of money to make sure that the > derivatives they offer are not pure "gambling," but rather have to do > with real things, like gold or IBM or Exxon. Because if they were just > gambling, they'd be illegal under state law, at least in the states > that prohibit gambling. > > Derivatives are about reducing risk, not about creating it. The reason > we need more regulation is that new, fancier derivatives were poorly > understood, so the financial institutions who bought them didn't know > how to properly hedge them. So, when they went bad, there was no > protection, and everything collapsed. Regulation is needed to make > sure that poorly understood derivatives aren't allowed - or that > financial institutions need to put much more money up to guard in case > of their collapse - and also to make sure that the financial system > isn't so interconnected that if one institution fails, all do. > > A final world on how derivatives are useful, using the orange juice > example again. Without derivatives, the orange juice company wouldn't > be able to invest that much money in new factories, because it would > always have to be worried about the ruinous effect on its profits of > an unexpected rise in the price of oranges. But if it is fully hedged, > by having invested in orange futures, then it no longer worries about > the price of oranges, and instead is free to invest its profits in > things like orange-juice-making factories. It needs much less of a > financial cushion, because it is properly hedged. So, the existence of > derivatives is a major reason for the wealth of modern economies over > the last century. Eliminating derivatives would produce a deadweight > loss - that is, all of a sudden, economies would be less efficient. >
Yup. I'm aware of that, as I worked in the financial markets for 12.5 years (with Bridge Information Systems before they were bought by Reuters). And, spent about 4 years working specifically with commodities. Your example of oranges is good, but there are two different markets for oranges, the actual fruit itself (and its derivatives, both futures and forwards and call and put options on both) and concentrated orange juice (with its futures and forwards and call and put options on both [options on futures is a whole 'nother aspect of derivatives of derivatives]), which lasts longer, yet doesn't satisfy a discriminating palate. The commodities market has always been and always will be a fabulous and vital market and must needs be traded in. Buying futures is great, but sometimes, one must actually buy the underlying commodity and, in the end, take delivery of that commodity. Otherwise, the actual commodities never get to be used. However, the 'average Joe', who wants to 'play' with commodities to see if they can gamble and win, must take great care that they don't end up with 10,000 head of cattle arriving at your 20th floor apartment. The average Joe NEVER wants to EVER buy a real underlying commodity, as it's just far too risky; in order to play safely, they are forced to play the derivatives and ensure that they buy back or sell off (depending on whether their original investment was a buy or sell, either way, they need to reverse the transaction before expiration or "take delivery") before the future turns into the REAL commodity upon expiration, which is the scenario I described above with 10,000 head of cattle (10,000 head is what each 'contract' of "Cattle Futures" represents and each commodity has its own 'contract'). Foreign exchange derivatives have also been useful, but, if you owned any Greek National Bonds, you would have recently discovered that Standard and Poors has just downgraded them to 'junk', so there's risk there, too. And, of course, I wouldn't be surprised by rogue traders trying to sell futures derived from Tibetan National Bonds in the hopes that someone is stupid enough to bet that China will, in the future, allow Tibet sovereignty. But such things as weather derivatives or the trading of pollution allowances is a completely different scenario. Not to mention the killer "credit derivatives" and "interest rate derivatives", which are the ones that have really taken the toll. Betting on the prices of real, tangible items such as oranges, concentrated orange juice or cattle is understandable and sensible as the trading of these must occur in order to maintain market stability as well as ensuring there is food available to reach peoples' tables. Equally, trading in metals, such as what occurs at the London Metals Exchange, is also vital for countless industries that require these metals to maintain production. But betting on the weather is just taking it too far. And, in my opinion, the trading of pollution allowances is, in effect, counter productive to the overall reduction in pollution that should be the goal of every company that produces so much that they have been granted an 'allowance'. These kinds of markets make a mockery of real markets like Oranges, Con. OJ, Cattle and metals. Nevertheless, it's all still gambling. And, whilst what is required is the trading of the commodities, the futures make it 'safer' to bet, of course, and options even safer, as they are one step removed from the future; but, in today's world, the concept of derivatives has gone beyond the necessities of economy and turned a legitimate market (that started, BTW, with tulips trading in Holland!) into a den of thieves and the thieves have, essentially, lured many in by the promise of a fast buck only to rape the clients' wallets and then pass their loss on as a credit derivative. So, again, you're right that regulations are required and we need to get back to basics and cut the nonsense out of the market. These days, derivatives are a game; whereas they were started with the intention of providing some safety, as you state. But, as we know, the road to hell is paved with good intentions. We can see, now, where the road leads and it's time to regulate and get the road straight again. > On Apr 28, 6:50 am, Pat <[email protected]> wrote: > > > > > On 24 Apr, 06:58, Slip Disc <[email protected]> wrote: > > > > We know that some people have made fortunes but is there really any > > > social value to what seems to be just gambling. Have we really gained > > > anything as a society or has it caused more ruin? > > > > Almost a year ago US Treasury Secretary Tim Geithner wants to regulate > > > the derivative > > > market.http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/53212... > > > > The wiki definition;http://en.wikipedia.org/wiki/Derivative_%28finance%29 > > > > Criticisms of the Derivative > > > Markethttp://en.wikipedia.org/wiki/Derivative_%28finance%29#Criticisms > > > > Below that the benefits which are clearly outnumbered by the > > > criticisms > > > > NPR discussion on the Diane Rehm show which you can listen to > > > here:http://thedianerehmshow.org/shows/2010-04-23/news-roundup-hour-1 > > > AUDIO:http://thedianerehmshow.org/audio-player?nid=12352 > > > > JeffreyC wrote: > > > > Diane, > > > > I am a dedicated listener and I love your show. However, today I was > > > very upset that none of your guests new anything about derivatives. > > > Their inability to describe how derivatives increase social welfare > > > demonstrates what little they know of finance and economics. More > > > upsetting is how they pretended to know and still commented, spreading > > > misconception and falsehoods. > > > > DERIVATIVES allow institutions to hedge against uncertainties, > > > effectively reducing risk and volatility in earnings and investment. > > > This is good for business as more predictable cash flows allow for > > > better planning and increased investment. This has a direct positive > > > effect on the welfare of an economy. Also, speculators are necessary > > > to ensure that all hedgers are able to place their hedges. The > > > speculator thus provides needed liquidity since all transactions need > > > two participants. > > > > THAT being said, the real topic is whether or not derivatives > > > transactions should only take place on a transparent exchange. > > > > PLEASE try to have someone trained in economics or finance on your > > > show when discussing matters of this type. Thank you. > > > > -- > > > You received this message because you are subscribed to the Google Groups > > > ""Minds Eye"" group. > > > To post to this group, send email to [email protected]. > > > To unsubscribe from this group, send email to > > > [email protected]. > > > For more options, visit this group > > > athttp://groups.google.com/group/minds-eye?hl=en. > > > It has caused much ruin. The amount of losses in the trading of > > derivitives is huge in comparison to other aspects of the market. On > > the order of 2-3 orders of magnitude. And it's not discussed as > > much. Of course, like all other aspects of the market, it's gambling, > > pure and simple. Although, unlike some markets, like commodities, > > it's as airy-fairy as it gets. Weather derivitives, for example. The > > social value is the same social value as gambling offers. Risk. > > Potential gain for no real effort (if you do well) or loss of all > > effort (if you don't). It's that 'chance' that you might undeservedly > > get that ever-so-elusive 'something for nothing'. Is it worth it? > > That would be a personal choice (yes, I use the word loosely). Social > > value? Well, again, the answer you would get from a winner on the > > derivitives market would differ from the answer you would get from a > > loser on the same market. Like all gambling, it's safer to just avoid > > it.- Hide quoted text - > > - Show quoted text -
