Independent, Fee-Only Financial Advisor

Independent, Fee-Only Financial Advisor

Thursday, June 07, 2012

easy math with derivatives

Expanded version here:

Derivatives. Scary stuff, right? If you hear it in the financial news, you probably know a little bit about them: they are huge and unpredictable and scary, right? In fact, a recent report points out that 75% of derivatives are concentrated on (or off) the books of six US firms. Thats a high concentration to be sure, but what does it mean?

How big is this market? It is actually huge. The Fitch report puts the notional size at $300 Trillion dollars. Uh, ok, thats big right? Do you realize how big of a number that is? $300,000,000,000,000. Thats a lot of zeros. For comparison, JP Morgan has 130,452,000,000 in net tangible assets (what they have minus what they owe) at last check and I just bought a small cup of coffee for $1.65, so that is 181,818,181,818,181.8 cups of coffee or 2,300 JP Morgans.

If you want the maths details, I have tried to work them out on my personal blog. Basically, the notional amount is like the principal on a loan, and it goes both ways. Each party owes that to each other, so that will cancel out. It is the cash flows on top that matter. The cash flows depend on interest rates, which are miserably small right now, so even on that $300,000,000,000,000, there may be only a few billion in payments going back and forth. That is manageable for the banks.

Yes, derivatives are HUGE, but their size may be exacerbated by the low interest rates right now. The two main issues with derivatives that I see are the complexity to people working with them, and their nature as off balance sheet items. If people working with them cannot properly hedge their risk away (which is generally the goal) there is still risk in holding it. If investors can't see what directional exposure exists, they cannot properly analyze the company.

Counterparty risk is a big deal. This is why AIG was bailed out so urgently - they were tied to just about everybody pretty much with the losing end of the deal every time. Their contracts obligated them to pay a lot of people a lot of money. If the contracts were not honored, everyone else would suffer along with them (a lot more than they obviously did).

Notional size is not what is important here, unhedged liability and counter-party risk is what matters. Just remember that when before the size of this market starts to frighten you.