A Simple Explanation of Derivatives

Posted on Jan 19, 2011 in Economic News, Featured Articles

Kevin Hayden

Dictionary definition of financial derivatives – Derivatives is the collective name used for a broad class of financial instruments that derive their value from other financial instruments (known as the underlying), events or conditions.


A financial instrument whose characteristics and value depend upon the characteristics and value of an underlier, typically a commodity, bond, equity or currency. Examples of derivatives include futures and options. Advanced investors sometimes purchase or sell derivatives to manage the risk associated with the underlying security, to protect against fluctuations in value, or to profit from periods of inactivity or decline. These techniques can be quite complicated and quite risky.

Are you lost when it comes to derivatives and financial instruments? When you hear the news talk about bundled toxic assets or future securities, do you wish there was a simple way to understand all of this nonsense without spending hours researching it? This simple article will help you understand and navigate through the maze of financial mumbo-jumbo in the headlines and secure a foundation upon which you can continue to research on. Understanding what these banks and financial institutions have been doing is paramount to financial survival and sanity in this epic age of Federal Reserve bailouts, quantitative easing and “Too Big to Fails.”

A simple explanation of derivatives –

Heidi is the owner of a small bar in Detroit.

She realizes that virtually all of her customers are unemployed alcoholics and, as such, can no longer afford to patronize her bar.

To solve this problem, she comes up with a new marketing plan that allows her customers to drink now, but pay later.

Heidi keeps track of the drinks consumed on a ledger (thereby granting the customers loans).

Word gets around about Heidi’s “drink now, pay later” marketing strategy and, as a result, increasing numbers of customers flood into Heidi’s bar. Soon, she has the largest sales volume for any bar in Detroit.

By providing her customers freedom from immediate payment demands, Heidi gets no resistance when, at regular intervals, she substantially increases her prices for wine and beer, the most consumed beverages.

Consequently, Heidi’s gross sales volume increases massively.

A young and dynamic vice-president at the local bank recognizes that these customer debts constitute valuable future assets and increases Heidi’s borrowing limit.

He sees no reason for any undue concern, since he has the debts of the drinkers (unemployed alcoholics) as collateral.

At the bank’s corporate headquarters, expert traders figure a way to make huge commissions trading these future securities, and transform the customer loans into DRINK BONDS.

These “securities” then are bundled together and traded on international securities markets.

Naive investors don’t really understand that the securities being sold to them as “AAA Secured Bonds” are actually packaged debts of unemployed alcoholics.  Nevertheless, the bond prices continuously climb and the securities soon become the hottest-selling items for some of the nation’s leading brokerage houses.

One day, even though the bond prices are still climbing, a risk manager at the original local bank decides that the time has come to demand payment on the debts incurred by the drinkers at Heidi’s bar.  He informs Heidi and calls the her debt due.

Heidi then demands payment from her patrons, but because they are unemployed alcoholics they can’t pay back their drinking debts.

Since Heidi cannot fulfill her loan obligations to the bank, she is forced into bankruptcy.  The bar closes and Heidi’s 11 employees lose their jobs.

Overnight, DRINK BOND prices drop by 90%.

The collapsed bond asset value destroys the bank’s liquidity and prevents it from issuing new loans, thus freezing credit and economic
activity in the community.

The suppliers of Heidi’s bar had granted her generous payment extensions and had invested their firms’ pension funds in the DRINK BOND securities.

They find they are now faced with having to write off her bad debt and lose over 90% of their pension value due to the BONDS tanking when it was discovered they were junk, or “toxic assets.”

Her wine supplier also claims bankruptcy, closing the doors on a family business that had endured for three generations.  Her beer supplier, having invested in and expanded his operations to handle Heidi’s increased demand for beer, suddenly has a massive overstock and expensive loan payments for his new equipment, now going unusued.

What once was a local brewery is now taken over by a national competitor, who immediately closes the micro-plant and lays off 45 workers.  They take the local product image and recipe and incorporate it into their global brand as the beer supplier fights law suits in court and loses his house due to legal costs.

Fortunately though, the bank, the brokerage houses and their respective executives who advertised the initial DRINK BONDS and suggested their clients invest in them are saved and bailed out by a multi-billion dollar, no-strings attached cash infusion from the government.  The Taxpayers.  These investment firms and banks held the very life blood of millions of other assets, loans and debts across the financial spectrum.

Many of these bonds, derivatives and loans – similar to the DRINK BONDS – were knowlingly packaged together and labeled ‘Grade A’ instead of calling them for what they truly were – high-risk junk.  If they were allowed to lose so much money on the DRINK BONDS, they would have to fold like the local banks and investors, causing a cascade of problems on all of their other hidden, toxic assets.

The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-drinkers who have never been in Heidi’s bar.

And instead of allowing these massive giants to topple so that we can rebuild based upon sound investment and quality assets, they are given more and more money in order to feed the toxic beast.  The money serves as a band-aid, placed on a gunshot wound.  It will continue to bleed toxicity until the entire system dies or implodes on itself.  The sheer amount of derivatives and bonds that are floating around surpass the global GDP.  Therefore, it is literally impossible to ever secure these assets and it is impossible to know which are toxic and which are quality until they show the signs and symptoms of failure.  At that point, it is too late.  The bubble has burst.
Now do you understand?

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