Monday, February 23, 2009

US$668 trillion (gross) or about 15 times the size of the world economy

Mystique of global crisis unravelled

From the article: The entire derivatives market is very large. Latest estimates point to US$668 trillion (gross) or about 15 times the size of the world economy. Their underlying worth is about US$15 trillion, slightly larger than the US gross domestic product (GDP). Now if deleveraging is taking place, why is this figure growing?

Posted by gardeniadotnet @ 12:32 PM (1704 views)
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17 thoughts on “US$668 trillion (gross) or about 15 times the size of the world economy

  • This is balls.

    Imagine a weather derivative where the seller pays the buyer £1 for every degree over 20c, and the buyer pays £1 for every degree below 20c.

    Now imagine that there are 100 of these contracts in existence.

    The temperature is not 2000c

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  • gardeniadotnet says:

    1. refusetobuy said… Imagine a weather derivative where the seller pays the buyer £1 for every degree over 20c, and the buyer pays £1 for every degree below 20c.

    Sounds like gambling to me.

    I sure hope all the losers are good for their debts.

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  • Gardenia –

    First the interest rate swap:

    So let’s say we both want to borrow some money for our companies (the same amount to keep it simple). The nature of my business is such that I’d prefer a fixed rate, and you’d prefer a floating rate. When we go to our banks we find that if we took out what we don’t want and swap the payments we end up paying less. Thus the interest rate swap was born – we have an intermediary to the swap and pay a small fee for that service, hence it becomes a business in it’s own right. The swaps allow a hedger or speculator to take a position in the underlying market (e.g. 3 month LIBOR), however the notional value overstates the positions to someone who may think about a loan, a bank account or an equity portfolio.

    In our example we may both want to borrow $1bn. I get offered LIBOR+1.25% or 7% and you get offered LIBOR+2.25% or 6%. If we took what we wanted we’d collectively pay LIBOR+9.25%, but if we took what we didn’t want and swapped the payments we’d collectively pay LIBOR+7.25%, saving ourselves 2% (some of this then gets eaten as a fee, but it’s still worth it). So the notional is $1bn, but the exposure is the three month settlement, plus any effects of the deal souring (one of use going bust). The former is about 1/4 of LIBOR+7.25% of $1bn (maybe $3.75m) and the latter would be the cost of either insuring against the outcome, refinancing the loan, or the uncertainty associated with continuing business with the wrong kind of outstanding loan.

    Now your question: If deleveraging is taking place, why is this figure growing? Deleveraging is happening and for many of the players involved this may only be sensibly achieved by swapping away the risks posed. This is hedging – and I imagine more and more of the contracts cancel each other out now – both players want to hedge their opposing positions, so they do – and effectively swap with each other (of course they probably don’t actually find each other), which reduces systemic risk as well. A clearing house would help clear things up as they could report some more meaningful numbers.

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  • So, in a nutshell: Some of it was and will be gambling, yes. Financial positions may be used to reduce or increase risk, but the notional does not have any bearing on how many players are increasing their risk or by how much, it’s just the notional on which the trades were made.

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  • gardeniadotnet says:

    Thanks again for your patience in trying to explain this, 51ck.

    And yet… I just cannot reconcile the fact that you (and bob1) can so quickly provide reasons that all these derivatives will effectively cancel each other out, while the macroeconomic environment continues to deteriorate rapidly.

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  • Aaagh!! Again! Gardenia, we’ve all told you before, you’re being told again, there’s a vast difference between gross and net exposure. Do you read anyone else’s comments, or just come on here to preach?

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  • I do not think they all cancel out in the way I described, just a lot of them! As I said a clearing house (or preferably competing clearing houses) would help add transparency to the state of the market.

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  • garden: one point worth noting is that many journalists use ‘credit market’ as a proxy for ‘derivatives market’. Obviously the credit market (CDO’s etc) is only a small part of the derivatives market. The figures in this article include all derivatives, most of which are harmless or actually beneficial.

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  • ontheotherhand says:

    Let’s say I grow wine and frost would destroy my harvest, or let’s say I run a ski resort and no frost would destroy my harvest (of skiers!). Weather derivatives allow me to buy ‘insurance’. Without it I might go bust on year.
    Isn’t it prudent to have insurance? If I don’t have any car insurance it’s a crime. Do we consider the insurance company to be gamblers because they are ‘betting’ that I won’t crash?

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  • gardeniadotnet says:

    bob1,

    A guy on Bloomberg today said the semi-nationalisation of the banks taking place ( Citigroup being the latest) will have a negative impact on the credit markets. What do you think?

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  • garden: It may well have a negative effect. The US treasury will have to issue more government bonds to cover the cost, at a time when there were already concerns about treasury debt issuance. Many people think that the extra govt borrowing to fund these semi-nationalisations will push bond supply beyond investor demand. You may have noticed that the bond market fell today directly because of the Citi news (obviously this pushes up interest rates). A healthy bond market is seen as a sign that the credit markets are thawing so anything that damages the credibility of the bond market is not so good.
    There is also the direct effect on the banks’ bondholders and other creditors. They could lose everything in a nationalisation. Same with depositors and institutional customers. These people, along with shareholders, are the suppliers of capital/credit. It’s easy to see how these nationalisations could cause panic in the wrong places

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  • gardeniadotnet says:

    @6 James

    No one has come close to convincing me of how this thing will unwind, while the gross figure ($668 trillion at the latest estimate) continues to increase. My problem, I suppose. Just ignore me.

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  • Say I sell one of the weather derivatives (from my previous post) to person A
    The amount outstanding is 20c
    Later I buy the same type of weather derivative from person B
    The amount outstanding is 40c (2 derivative contracts)
    My position has been netted, the total net position is the same but the gross amount has increased.

    While contracts are still alive it’s quite easy for the gross position to increase, whilst the net stays constant.

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  • Good explanation of derivatives, not nil sum but far closer than some would suggest. I actually think the confusion about deriviatives allows the govts to divert blame outside, its the shadow banking system, nothing to do with us or the systemic pushing of debt.

    But at root its a mundane problem of too much debt with regards to income, justrified through the notion that all types of commerical and residential property would go up and price. Securitisation and that idea that it was secure was the problem.

    Even CDO’s a sub species of derviatives were undepinned by this myth, there were mathematical formula showing how the debtors were not correlated but really noone understood these(bcos they didn’t actually make sense!) but bought into them because it didn’t matter because the property at the end of the chain only ever went up in price and therefore the debtors didn’t matter.

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  • methinks this might alter some perspectives on this thread. I thought I’d posted it yesterday but it was earlier today and got whacked for some reason. Point being if the real US deficit exceeds world GDP what is the world deficit and where/who etc did all that money come from if it wasn’t &^%$£!”$^*^% etc ?

    ~~~~~~~~~~~~~~~~~~~~~~~~~

    Monday, Feb 23, 2009Federal obligations exceed world GDPMONEYNETDAILY: Does $65.5 trillion terrify anyone yet?
    OK this article is dated 13th feb BUT it just appeared in my inbox this morning and it follows in a series of threads relating to getting our heads around ‘trillions’. ~~~~ the American public is largely unaware that the true deficit of the federal government already is measured in trillions of dollars, and in fact its $65.5 trillion in total obligations exceeds the gross domestic product of the world.
    The total U.S. obligations, including Social Security and Medicare benefits to be paid in the future, effectively have placed the U.S. government in bankruptcy, even before new continuing social welfare obligation embedded in the massive spending plan are taken into account.

    Posted by troy @ 04:42 AM
    ~~~~~~~~~~~~~

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  • gardeniadotnet says:

    @13. refusetobuy – now we’re getting somewhere! Thanks for that.

    So it’s now time to pay the piper. ‘Let’s see who’s left holding the bag’, as I believe the jargon goes.

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  • @ontheotherhand: the Credit Default Swap allows *me* to bet that *you* won’t crash, and collect if you do. What loss have I suffered? None. That’s what makes it a bet rather than insurance.

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