Minus Sum Game Mk II - Derivatives

DionysusToast

DionysusToast

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For those not in the know. My opinion is that Wall St exists for much the same reason as a casino and makes money in much the same way. Investors of all types put money in and Wall St skims itself a fee/spread each time they do that.

Now I'd like to focus on derivatives, especially those commodity based derivatives. Is there actually a reason for their existence ? Are they not just another means to suck money out of an economy that doesn't need derivatives in the first place ?

The story goes that derivatives help buyers and sellers guarantee prices and avoid the pitfalls of price volatility. The questions you have to ask is
1) does this work ?
2) Are prices less volatile with commodity derivatives than without them ?

Of course, the exchanges benefit from volatility. Volatility entices people to trade and incurs fees. Not only that but there are literally billions of dollars in margin kept in escrow by the exchanges on which they earn interest. From the exchanges point of view, it makes a lot of sense to have derivatives and for those derivatives to be volatile. Does it really make sense for the rest of us ? Isn't hedging just a Wall St invention that tells us we are being wise to pay more fees & lose money to mitigate risk ?

What about from a corn buyers point of view ? He can buy a corn contract and when it goes down, he can pat himself on the back that although he didn't need the derivative, he did in fact insure himself against rising prices. Somehow he's been convinced that losing money on derivatives is good for business. The thing is, would the prices have been that unstable anyway - or are the derivatives markets and the speculation it attracts causing the volatility ? Oil anyone ?

There are even derivatives on - call minutes used, the weather (degree day indices), clean air days etc. is this anything but pure gambling on the weather ? What purpose really is the S&P500 futures ?

Don't even get me started on Cap and Trade...

So - do derivatives serve a purpose ? I don't mean their stated purpose, I mean do they actually do what they say they do ?

And the big question "What does this have to do with the price of onions ?"
 
I was an institutional trader of derivatives for many years and I believe their main purpose is to earn bid/ask for the market makers. Now I'm trading my own book, I don't touch them, it just adds additional layers of unnecessary complexity.
 
meanreversion said:
I was an institutional trader of derivatives for many years
Click to expand...

white-gangsta.jpg


http://www.youtube.com/watch?v=DT1KRZOK4VE&feature=related

Pleased to meetcha, woncha tell me ur name.

:LOL::LOL::LOL:
 
Hehe just kidding mate.

But I agree with your take above tho.

So does he.

:D

liars-poker.jpg

Liar's Poker: Rising Through the Wreckage on Wall Street

Good read.

But one shouldn't ever forget that it takes 2 to tango is my opinion, and it's only legitimate that a banks first interest should be it's own profitability, banks aren't charities after all are they.
 
Absolutely a minus sum game! Having said that I think they (and I'm thinking particularly of futures markets) do have a role in price discovery, more market participants the better really. Some would argue of course that some of those participants have a negative impact e.g. retail traders adding volatility because they're 'weak hands' with close stops accentuating pullbacks, large commodity funds piling into commodities as another asset class and driving up prices. That said in real commodity markets like Cotton the commercial's still take up around half the open interest.

You make a good point about onions, I did read some academic articles about the onion market after the futures were closed, Holbrook Working said prices were more volatile after the futures closed, Aaron Johnson said the opposite! Time for a revisit.

I've tried finding some really good historic charts of volatility for commodities with long history but haven't had much joy yet. Would be interesting to see what percentage volatility looks like back in the early part of this century when these markets were allegedly a bit less speculative than they are now.
 
DionysusToast said:
For those not in the know. My opinion is that Wall St exists for much the same reason as a casino and makes money in much the same way. Investors of all types put money in and Wall St skims itself a fee/spread each time they do that.

Now I'd like to focus on derivatives, especially those commodity based derivatives. Is there actually a reason for their existence ? Are they not just another means to suck money out of an economy that doesn't need derivatives in the first place ?

The story goes that derivatives help buyers and sellers guarantee prices and avoid the pitfalls of price volatility. The questions you have to ask is
1) does this work ?
2) Are prices less volatile with commodity derivatives than without them ?

Of course, the exchanges benefit from volatility. Volatility entices people to trade and incurs fees. Not only that but there are literally billions of dollars in margin kept in escrow by the exchanges on which they earn interest. From the exchanges point of view, it makes a lot of sense to have derivatives and for those derivatives to be volatile. Does it really make sense for the rest of us ? Isn't hedging just a Wall St invention that tells us we are being wise to pay more fees & lose money to mitigate risk ?

What about from a corn buyers point of view ? He can buy a corn contract and when it goes down, he can pat himself on the back that although he didn't need the derivative, he did in fact insure himself against rising prices. Somehow he's been convinced that losing money on derivatives is good for business. The thing is, would the prices have been that unstable anyway - or are the derivatives markets and the speculation it attracts causing the volatility ? Oil anyone ?

There are even derivatives on - call minutes used, the weather (degree day indices), clean air days etc. is this anything but pure gambling on the weather ? What purpose really is the S&P500 futures ?

Don't even get me started on Cap and Trade...

So - do derivatives serve a purpose ? I don't mean their stated purpose, I mean do they actually do what they say they do ?

And the big question "What does this have to do with the price of onions ?"
Click to expand...



The SP500 futures contracts? Which size are you referring to?
 
Take the options market. It originated as a method for exporters to hedge, by buying insurance (options) and yes, it does make sense. In the same way that car insurance makes sense, so does buying options to hedge, where required. But then it went too far, first knockout options were created, then one touch options, range binaries and more. These are purely vehicles for speculation, and this kind of product development can be seen with CDO, CDS and the like.

If new instruments are created purely for speculation (with sports, it might be total goal minutes or multi-corners), the market is then more of a casino.
 
meanreversion said:
Take the options market. It originated as a method for exporters to hedge, by buying insurance (options) and yes, it does make sense. In the same way that car insurance makes sense, so does buying options to hedge, where required. But then it went too far, first knockout options were created, then one touch options, range binaries and more. These are purely vehicles for speculation, and this kind of product development can be seen with CDO, CDS and the like.

If new instruments are created purely for speculation (with sports, it might be total goal minutes or multi-corners), the market is then more of a casino.
Click to expand...


But the markets are highly correlated, UK100, SP500, they are both arbed in, these are not randomly moving markets, and certainly not traded randomly.

Who is moving all of the derivatives in unison, surely size and contract value must come into the equation?
 
I don't normally like to quote myself..

DionysusToast said:
And the big question "What does this have to do with the price of onions ?"
Click to expand...

Did someone mention onions ???

Mon, 04/19/2010 - 00:11 EDT The financial reform bill being considered in the US Senate aims to impose stricter supervision of all derivatives and prohibit futures based on box-office receipts and the price of onions
Click to expand...

Did someone mention gambling ???

Wed, 04/21/2010 - 16:55 EDT A proposed ban on betting on movie box office receipts took one step closer to becoming law. A U.S. Senate committee on Wednesday passed a financial regulatory reform bill that supports Hollywood in outlawing the trading of futures contracts based on predicted movie ticket sales.
Click to expand...

To be honest, the onions thing is very amusing because I was unaware that they were trying to bring back onions derivatives when I wrote the post. I wonder who's behind the drive to bring back onions derivatives ? The farmers ? The wholesalers ? The exchanges and brokers ???? I know which my money is on.

The Onion Futures Act (7 U.S.C Chapter 1 § 13-1]) is a United States law banning the trading of futures contracts on onions. It was passed on August 28, 1958, and remains in effect as of 2010[update].

This law is notable as the first and only ban on the trading of futures contracts of a specific commodity in United States history, and as a unique modern case with which to study the effects of the existence of an active futures market on commodity prices. In particular, proponents of futures markets often claim that they serve to stabilize otherwise volatile commodity supplies (and thus, prices) by providing a market-driven consensus mechanism for future price estimation. The conclusions drawn in subsequent studies of the effects of the Act upon price volatility have been mixed.
Click to expand...

You can look up the research yourself. What is interesting is that research does show that prices were more volatile when the futures contracts existed.

So - whilst a futures markets can be used for hedging, it can be argued that it is the futures market itself the causes the need to hedge. Hedging protects you from the adverse effects of price volatility but the future markets are a major cause of that volatility.

Anyone looking at the oil market and the world economy will know that oil prices are not all about the supply and demand of the product.

Are we to believe that oil prices would be more volatile without oil futures ?
 
BSD said:
But one shouldn't ever forget that it takes 2 to tango is my opinion, and it's only legitimate that a banks first interest should be it's own profitability, banks aren't charities after all are they.
Click to expand...

Maybe, maybe not.

If the markets cause volatility and ensure that certain people in those industry have to participate because of the actions of speculators, then there are some genuine victims.

There is also the impact on the consumer because the costs of trading/hedging will ultimately be passed on to them.

Of course, no-one makes the speculators play, nor should we sympathise when they (we) lose but this is not victimless grime.
 
Toast, if one looks at the big picture you're right, as we all saw in the financial crisis that was essentially caused by banks mass marketing housing credit to people who couldn't afford it before bundling em up and selling em on in sexy derivatives that Warren Buffett quite rightly called toxic weapons of mass destruction.

http://www.independent.co.uk/news/business/news/a-163516-trillion-derivatives-timebomb-958699.html

So markets clearly can't function without regulation or supervision, I think we were really lucky that things didn't turn out far worse.

But all that still isn't a "go-free" card for people to quit their thinking processes just because they see some sexy advertising.

No matter if it's a home buyer who can't afford a home loan and then shouldn't con themselves into thinking they can, or that magically housing prices will keep spiralling ever upwards in merry bubbles saving their ass at the end of day.

OR the clever guys higher up the food chain buying and trading with the structured products who also largely didn't know what they were doing, but greed put a quick end to any doubts there too.
 
Actually, the point about oil futures is a good one. Remember when the price went to $147 or so, they were blaming "speculators". Now, that's silly isn't it, as speculators never take physical delivery of oil, surely they can't move the price that far. However, I recall reading that Ryanair pulled the trigger on their hedging needs for 3 years when oil was around $120... i.e. they bought oil forward for delivery. So in this case, the speculators DID cause the move as they forced the real end-users into buying at high levels.
 
BSD - Houses are a good example.

What if there was a housing futures market for the prices of new homes ? Would we all be happy for the very trustworthy Goldman Sachs to run a futures market to which the price of future home supply would effectively be pegged ?

What do we think would happen if trillions of dollars were pumped into this market and the price of new homes became unpredictable (as oil) because of this new market ? Or would this market make house prices more stable ? If so - how ? Would we not see speculators all running for the doors at the same time when it appeared prices were weakening ? Would we not also see speculators bidding prices up in times of growth ?

These markets create the problem they are intended to prevent and there are plenty of people forced to join the game to stop becoming it's victim.

Of course, I am not saying this was intentional...
 
BSD said:
OR the clever guys higher up the food chain buying and trading with the structured products who also largely didn't know what they were doing, but greed put a quick end to any doubts there too.
Click to expand...

Is this hilarious or what, Goldman Sachs's fabuluous Fabrice Tourre, sounding off on what he thinks of his derivatives, SEC dug this up when they charged Goldman with fraud:

fabrice_1618235c.jpg


“More and more leverage in the system. The whole building is about to collapse anytime now ... Only potential survivor, the fabulous Fab[rice Tourre] ... standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implication of those monstruosities [sic]!!!”
http://www.telegraph.co.uk/finance/...nd-the-complex-Abacus-of-toxic-mortgages.html

Actually not really funny at all tho.
 
futures markets, as with any markets are driven by supply and demand so asying they effect supply and demand is a null and void point.

the problem/beauty with derivatives is simple: leverage. or rather the ease of over-leveraging.
 
meanreversion said:
Actually, the point about oil futures is a good one. Remember when the price went to $147 or so, they were blaming "speculators". Now, that's silly isn't it, as speculators never take physical delivery of oil, surely they can't move the price that far. However, I recall reading that Ryanair pulled the trigger on their hedging needs for 3 years when oil was around $120... i.e. they bought oil forward for delivery. So in this case, the speculators DID cause the move as they forced the real end-users into buying at high levels.
Click to expand...

Indeed.

It is the difference between the following
1) supply and demand of a physical commodity between people who buy/sell the commodity
2) supply and demand of contracts between people who buy/sell the contracts and can roll them over so as never to have to worry about the physical commodity itself

It gets worse though - these derivatives are not cheap to play, so some monkey goes and puts a derivative on the derivative (OK - so not quite) and we have ETFs buying the contracts on behalf of people with just a few hundred dollars to punt.

Of course, this is good for the ETFs and the exchange, who get their fees but in some cases the ETF itself corners the market. Wasn't it UNG that at some point represented most of the natural gas futures contracts ?
 
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