Credit Derivatives

I and the other 9 people borrow some money from you $100 each with interest at $15. At the end, if we payback all of our debts to you, you would receive $1000 plus $150 interest, totalling $1150.

Knowing that you would have $1150 at the end, you then simultaneously borrow from 100 friends of yours for $10 each promising them $1 interest. Everyone of your friends would receive $11 from you at the end, costing you in total $1100.

At the end, you would get $50 without actually having the $1000.

Other way.

You know that there is a risk of us not paying you back. We would pay back the interests, but may not pay back some part of our debts. You then find a special friend of yours and telling her about this.

Your friend asks you to pay $100 in advance as she promises to cover any loss you get at the end. She may expect that you might just get $925 back from $1000. She would then pay the rest of $75 to you.

If you really just get $925 back, you still get $1000. However, your interest profit of $150 needs to be deducted by $100 protection from her who has promised to cover your loss. Your total profit is now $50. It is less but at least you still get some profit here. Meanwhile, your friend receives $100 from you and pay $75 to cover your loss. She in total gets $25 profit.

If you get back all of the $1000, your total profit would be still $50. However, she would be better off as receiving $100 from you without covering your loss.

She is such a great speculator, isn't she? How about if you just get $700 back from $1000 you lend to us?

Another way.

One big guy pays you $50 now and $1000 at the end whatever the situation would be and asks you to tell your friends to pay him all what they owe you ($1150) at the end.

You get an instant profit of $50 now and he would get a profit of $100 at the end if your friends pay all of their debts.

If your friends might not pay some of their debts, it would be his problem because you would still get your $1000 from him.

Clip from Economist.

Bankers themselves are fuzzy about explaining their trading profits, bandying about phrases such as “deploying our intellectual capital”. But it is clear that three powerful forces are at work, all of them overlapping and mutually reinforcing, and all fundamental to the gushing liquidity the world is currently enjoying.

The first is the alchemist's trick of turning debt (mostly leaden) into derivatives (mostly liquid); the second is the emergence of a new class of leveraged client (hedge funds and private equity); and the third is seeking out new capital markets, and clients, around the world. Moreover, in all these pursuits the firms are now using not just their clients' money but, to differing degrees, their own too. (read more)

Clip from Mises.

The example might help in putting into perspective the breathtakingly strong growth of the credit derivative market. A credit derivative (in the form of, for instance, a credit default swap, total return swap, or credit linked note) is a contractual transfer of the risk of a credit from one market agent to another (without transfer of the underlying asset). Early forms of credit derivative are, for instance, financial guarantees.

The total market volume of credit derivatives outstanding was an estimated US$20.2 trillion in 2006, amounting to around 1.5 times annual nominal US GDP, up from just US$1.2 trillion seen in 2001 (Figure 2). The market is expected to grow further to US$33.1 trillion until 2008. In fact, the credit derivative market has become the biggest market segment of the international banking business already. (read more)