Another economics question - should derivatives be banned ?

[Yoga Face]

The stock market is in the business of getting money to entrepreneurs who need it to create industry and jobs

IE I want to expand my factory but need money so I sell shares

Is the use of derivatives a necessary part of this liquidity flow ???

It seems to me that going long or short on the market, commodities or the dollar is a game that offers nothing to the purpose of the market and may even cause damage as well as entice part-time day traders to lose everything (the same way gambling does)

I have read where Germany wants to ban short selling of the Euro ( betting it's value will go down) to create stability

 

[JohnLarue]

The stock market is in the business of getting money to entrepreneurs who need it to create industry and jobs

IE I want to expand my factory but need money so I sell shares

Is the use of derivatives a necessary part of this liquidity flow ???

It seems to me that going long or short on the market, commodities or the dollar is a game that offers nothing to the purpose of the market and may even cause damage as well as entice part-time day traders to lose everything (the same way gambling does)

I have read where Germany wants to ban short selling of the Euro ( betting it's value will go down) to create stability

Is the use of derivatives a necessary part of this liquidity flow ???

ABSOLUTELY

The primary use of derivatives is to reduce risk
And when used for that purpose, they are extremely valuable tools
When they are used to speculate, they can greatly increase risk

Example 1.
You know that you will need to borrow money for your factory expansion, but not for 9 months and you know the interest rates are going up.
If rate go up too far the factory expansion no longer makes sense.

A forward rate derivate can lock in today, a set borrowing rate 9 months from now that makes the expansion project viable.

Example 2.
A farmer is confident of how many bushes of corn he will harvest in the fall and at the current price per bushel he knows he will make a profit
He is worried the price will fall and turn his profit to a loss

He sells his corn forward at a set price and locks in a profitable year.

Example 3.
A pension company knows that in 4 years a large number of new retires will start to draw on their pension early due to changing regulations
The pension fund hold a lot of 5 year bonds, which will mature one year too late to fund these unexpected pension draws
The pension company can enter into an interest rate contract to match up the cash flows from the assets (bonds) and the liabilities (pension payouts)

In each case derivatives were used to reduce risk

Now if you go and sell a derivatives contract without the proper offset (ie selling wheat contracts to a cereal company without having a buy contract from a farmer), you have made a directional bet on the price and if you are wrong, you are fucked.

AIG did this by writing a huge number of contracts to guarantee the value of mortgaged backed bonds.
They made a ton of money as long as everyone paid their mortgage.
When the US housing market collapsed , they were left having to honor more contracts than they could fulfill
They used derivatives to speculate , they guess wrong and they got fucked. (actually it was the taxpayer who got bent over in this case)

 

[Bear669]

Excellent summary from Larue..

The stock market is in the business of getting money to entrepreneurs who need it to create industry and jobs

IE I want to expand my factory but need money so I sell shares

Is the use of derivatives a necessary part of this liquidity flow ???

It seems to me that going long or short on the market, commodities or the dollar is a game that offers nothing to the purpose of the market and may even cause damage as well as entice part-time day traders to lose everything (the same way gambling does)

I have read where Germany wants to ban short selling of the Euro ( betting it's value will go down) to create stability

..and short selling can fit within his example as well.

However, even from a PURE speculation POV, HONEST* short sellers do NOT cause a stock to go down.
ONLY the absence of willing buyers, causes stock prices to drop.


(* that means no libel, no slander and no spiking Maple Leaf meat with razors while you sell short!)

 

[odie999]

I have read where Germany wants to ban short selling of the Euro ( betting it's value will go down) to create stability

As far as I know that's an incorrect over-simplificaton.

If you have an insurable interest in the Euro you may still write derivatives against the Euro.

No insurable interest, no derivatives.

It's no different from insurance: you are NOT allowed to take out insurance on your neighbor's house unless you own part of it.

Insurance companies may not sell you insurance until you prove you have an insurable interest.

Courts of law do not uphold contracts of insurance where there's no insurable interest.

That's what the German ban is doing - bringing the reasonable law of insurance to the insurance products known as CDS. That's what CDS is supposed to be - NOT outright gambling.

 

[danmand]

I think short selling should be banned. You can protect yourself through bying puts etc.

 

[burt-oh-my!]

Derivatives have many advantages.

Extraordinarily low transaction costs are one of them. Using stock index futures as an example, if a pension fund wants to quickly adjust their exposure to the stock market, say by $50 million, rather than laboriously buying / selling individual stocks, they can in one quick, extremely cheap transaction do the same thing via futures contracts. The commissions based on the underlying exposure are minimal. Futures transactions can also be much faster, and the liquidity is often far greater, at least for traded contracts, than trading the actual underlying commodity/financial security. So slippage and losses due to the bid/ask spread (which can often be greater than the commission) are also minimized.

Leverage - well, leverage actually contributes to the cheapness, because you don't have to put as much up to get the exposure you want.

 

[Yoga Face]

Great answers but I already knew that they are a form of insurance

What I really meant to ask is what about day traders who do nothing but gamble with derivatives ???

Quite popular as anyone can do it and takes only a simple course to learn how

It seems to me this is gambling and

- Serves no purpose and it may even cause market instability

- Is exactly like gambling which leads those prone to the adrenalin rush susceptible to lose all which is why gambling is restricted

I can see no good in this so should it not be banned ???????

 

[DocOdd]

Short-selling is actually beneficial to a functioning market; the problematic derivatives are the more complicated ones, which enable leverage to be increased and concealed (it's leverage that transforms a down-turn into a collapse, not short-selling), and which facilitate securities fraud (especially misrepresentation of risks).

 

[Bear669]

Two thoughts...

Great answers but I already knew that they are a form of insurance

What I really meant to ask is what about day traders who do nothing but gamble with derivatives ???

Quite popular as anyone can do it and takes only a simple course to learn how

It seems to me this is gambling and

- Serves no purpose and it may even cause market instability

- Is exactly like gambling which leads those prone to the adrenalin rush susceptible to lose all which is why gambling is restricted

I can see no good in this so should it not be banned ???????

a) The speculators help make a big liquid market for the investors and producers who have a specific and prudent need to be on the other side of the trade.

b) Why shouldnt adults in a free and capitalist society be allowed to bet on WHATEVER they want?

 

[WoodPeckr]

b) Why shouldnt adults in a free and capitalist society be allowed to bet on WHATEVER they want?

Because in general, gambling is illegal....except on Indian Reservations, Vegas and Wall Street!....

 

[burt-oh-my!]

Great answers but I already knew that they are a form of insurance

What I really meant to ask is what about day traders who do nothing but gamble with derivatives ???

Quite popular as anyone can do it and takes only a simple course to learn how

It seems to me this is gambling and

- Serves no purpose and it may even cause market instability

- Is exactly like gambling which leads those prone to the adrenalin rush susceptible to lose all which is why gambling is restricted

I can see no good in this so should it not be banned ???????

I think that the best way to answer this point is to think about what a day trader actually does. but firstly, one caveat: I am talking about a SUCCESSFUL day trader. Unsuccessful day traders will eventually disappear just as any other inefficient or unprofitagble business will

So what do they do? The siimple answer is that they buy and sell, and of course on average they have to buy lower than they sell, and vice versa. Now, if I buy , for example, and sell later that day at a higher price, then in effect my buying contributed just a teeny bit to SUPPORTING the market when it was low, and sellers (suppliers) were looking for buyers, and I SUPPLIED the market when buyers were looking for supply, so I a teeny bit DAMPENED the rise in the market. They are fulfilling an economic function.

If they aren't,they eventually go bust, and provide a source of additional profits to the successful speculators/traders.

 

[Bear669]

Thats not an answer....

Because in general, gambling is illegal....except on Indian Reservations, Vegas and Wall Street!....

....and lotteries, and scratch and play cards, and in the UK, and Monte Carlo and Hong Kong...

 

[WoodPeckr]

LOL!
It's a slippery slope.....

 

[hinz]

Because in general, gambling is illegal....

Sounds every bit like a right wing nut job you despise.

 

[fuji]

"Ban all derivatives" is too broad. Many types of derivatives are useful and necessary parts of the modern commercial system.

I think we could have a useful discussion around whether SOME types of derivatives should be banned, like credit default swaps.

But if you mean ban puts and shorts on stocks, or ban currency futures, or ban wheat futures, well I don't think so. Put some strict regulation in around their use and such, sure, like an uptick rule and such, but don't ban them.

ban short selling of the Euro

Now THAT is ridiculous.

Let's say you are a Canadian factory owner and you get a contract to produce a $10 million dollar order for delivery to a Euro country. You are going to be paid in Euros, and basically you want to make sure that you get the Canadian dollars you think you just earned. You are worried that if the Euro changes in value that you are going to lose money on the deal that is profitable at today's exchange rate.

So you buy a forward contract on the Euro that locks you in at today's exchange rate and guarantees that your deal is going to be profitable, even though you aren't going to get paid for the order for six months.

 

[someone]

I have read where Germany wants to ban short selling of the Euro ( betting it's value will go down) to create stability

I have not been following the details but I have wondered how Germany’s ban on Euro short selling is really enforceable. I don’t see what is to keep German firms from just making the transactions through France/UK/etc. subsidiaries. Indeed, it would seem to give German firms and incentive to set up such subsidiaries.

 

[JohnLarue]

"Ban all derivatives" is too broad. Many types of derivatives are useful and necessary parts of the modern commercial system.

I think we could have a useful discussion around whether SOME types of derivatives should be banned, like credit default swaps.

No need to ban credit default swaps
They also serve a very useful purpose for market players who wish to reduce their credit risk and concentration in maturity, geography and issuer.

No need to ban any derivatives.
The products are not the problem. It is their application in a speculative manner which is the problem.

What is required (if you assume something needs to be done) is the application of better risk management.

Possibly limits on specific exposure to certain markets as a % of capital.
However, prudent Institutions should already have these limits in place
Govt Regulation of these exposures is an extremely difficult proposition due to
a) volatility
b) volumes
c) the complexity of some of the instruments- The FI s have thousands of mathematical genius developing these instruments, Is the govt going to be able to identify and isolate the risky positions?
No, never in a million years.
Most will have expired long before the govt even gets the data



A clearing house concept similar to the commodity exchange futures market applied to the over-the-counter market is a possibility, however the OTC market is massive relative to the exchange.
Such a change would add a lot of layers of administration and costs into the system.
I suspect the OTC interest rate derivatives market volume alone would choke an exchange clearing house and may disrupt the efficiency of the market
Foreign exchange is another OTC market where the notional $ amounts are astronomical.


Any changes to these markets should be very carefully thought out.
A ready, shoot, aim approach would be disastrous

 

[Yoga Face]

a) The speculators help make a big liquid market for the investors and producers who have a specific and prudent need to be on the other side of the trade.

I am not so sure but are there no alternatives ??? Are we controlled by this elite ???? How about the damages they cause ??? I suspect money changers make $$$$$$$$ if they can cause a collapse in some third world country

One of capitalisms great failings is that money changers are the richest of us and these money changers are brilliant folks. What a sad waste of intelligence

b) Why shouldn't adults in a free and capitalist society be allowed to bet on WHATEVER they want?

I am all for freedom

I believe in full school vouchers so people can educate themselves as they see fit but common sense needs to prevail

In the case of gambling it causes social damage and destroys lives and families which we all pay for



Look, some people have a weakness to gambling and are addicted, that is why

 

[Yoga Face]

I think that the best way to answer this point is to think about what a day trader actually does. but firstly, one caveat: I am talking about a SUCCESSFUL day trader. Unsuccessful day traders will eventually disappear just as any other inefficient or unprofitagble business will

So what do they do? The siimple answer is that they buy and sell, and of course on average they have to buy lower than they sell, and vice versa. Now, if I buy , for example, and sell later that day at a higher price, then in effect my buying contributed just a teeny bit to SUPPORTING the market when it was low, and sellers (suppliers) were looking for buyers, and I SUPPLIED the market when buyers were looking for supply, so I a teeny bit DAMPENED the rise in the market. They are fulfilling an economic function.

If they aren't,they eventually go bust, and provide a source of additional profits to the successful speculators/traders.

Very interesting comment
I never thought of it

I do not think your answer is definitve even though it is a good one

 

[Bear669]

If by "elite' you mean money changers/speculators....

I am not so sure but are there no alternatives ??? Are we controlled by this elite ???? How about the damages they cause ??? I suspect money changers make $$$$$$$$ if they can cause a collapse in some third world country

One of capitalisms great failings is that money changers are the richest of us and these money changers are brilliant folks. What a sad waste of intelligence


I am all for freedom

I believe in full school vouchers so people can educate themselves as they see fit but common sense needs to prevail

In the case of gambling it causes social damage and destroys lives and families which we all pay for


Look, some people have a weakness to gambling and are addicted, that is why

You need to go waaay down the list before you find the 'richest' currency speculators- Bill Gates, Warren Buffet, Slim- then hosts of other types with fortunes in realty, inheritances etc.

Also keep in mind, I defended HONEST short sellers. I am well aware that many types of 'capitalists' cheat like crazy and more need to go to jail.
There are all kinds of evil ways to crash a 3rd world economy (Hmmm even a first world), but short selling is not one of them.

Keep in mind honest short sellers take HUGE risks, and often lose. Again-

ONLY the absence of willing buyers drives down a stock, commodity or currency.

As far as gambling/speculating- cigarettes & liquor are bad too- but hey adults all have the right to got to hell in their own fashion.