Credit Crisis explain 

Whenever economists or bankers (or others of that ilk) begin talking about the current financial situation they will eventually drift into jargon and most of the time they drift into it pretty quickly. “Mortgage Backed”, “Leveraged”, “Swaps”, “C.F.D’s”, “SN’s” and eventually everybody begins to think “H.E.L.P”. As soon as we start talking in abbreviations and initials it is fair to assume that “derivatives” are involved.

At the heart of the current crisis are these “derivatives” so what are they? Put simply a “derivative” is a “financial instrument” (sorry- a cheque is a financial instrument as is a mortgage) whose value depends upon something else.

Let’s assume you need 500,000 barrels of aviation fuel next April and you are worried about how much it might cost. You could buy it all now at $100 a barrel but if the prices goes down you’ll feel an idiot for paying too much. You could just wait until you need it and buy it then, but if the price goes back up you’re back in Idiotsville. What to do?

 You buy a simple basic derivative known as a “call option” - this gives you the right (but no obligation) to buy the fuel at a price agreed today say $110 a barrel. You pay the option seller a small premium, say $2 per barrel, and wait to see what happens. If the fuel price falls you have lost the premium (do you cry about the waste of your buildings insurance premium if your house doesn’t burn down?)  But you don’t buy the fuel at $110.

If the price rises to say, $113 you have won. You exercise your right to buy at $110 so with the $2 already paid the fuel has cost you $112. Notice I said you have won. The option writer has lost. He has to supply you with the fuel at   $110 even if he has to buy it at $113. At the heart of every derivative is this core element of a gamble. The more the price rises above $112 the more you are winning.

Bear with me whilst we jump forward to February, the price of fuel leaps back up to the $150 per barrel and you are “quid’s in”. The “call option” that you
have was an excellent buy and now has a value. At the same time you realise that you only need 400,000 barrels. You can keep all your bet and then sell
the spare 100,000 barrels after you have bought them in April, OR you can sell part of this option (for 100,000 barrels) to somebody else. Effectively you are selling the right to buy fuel at $110 a barrel which currently costs $150 – if you sell this for $30 then you have made a profit of $28 ($30 less the $2 you paid) and the buyer gets the oil for $140 ( $110 + $30). Still cheaper than the open market.

By now I’m sure you’re thinking of all the ways this can go wrong. Yes, the price could fall back from $150 in which case your buyer has lost or the value could rise and you could have made more money by not selling until March etc. And this is a simple derivative, variants of which have been around for hundreds (possibly thousands) of years - one commentator expressed the view that there is one in Genesis.

And these have been operating successfully and well so where has it all gone wrong? Things began to get a little more complicated when people who didn’t need fuel bought call options just because they believed oil prices would rise. Or conversely started writing the option, i.e. promising to sell the fuel (which they didn’t have) hoping that prices will fall and they will never be asked to supply.

And then things got middling complicated when options are written not on real assets (such as fuel) but on financial assets such as currency, interest rates and mortgages – we are back at the “sub prime” again.

Effectively AnyBank lent money to people to buy houses via mortgages. And then ran out of money to lend to new customers. So they sold the mortgages to a third party with the price based on the interest rate the borrowers are paying and the value of the loans against the value of the houses. The money they got from this they then lent to more people to buy more houses (or lent more to existing customers to improve their homes).

These third parties then persuaded a fourth party that the bundle of mortgages they had bought from AnyBank were worth more than they’d paid AnyBank. They then used this money to buy another bundle from AnyBank and on and on. And as soon as property values fell it all came tumbling down.

According to “What Car” the performance car of the year is the Audi R8. It does 0- 62 in 4.6 seconds and has a top speed of 187 mph. (why?) Obviously, in most hands, this thing is too powerful to handle but does this mean all cars are bad?  At the other end of the “What Car” survey the best small family car of the year is the VW Golf 1.4 TSI 120 Match 5 Dr. It takes twice as long (9.4 seconds) to get to 62 and (bless it) can only manage 122 mph.

Our modern economies need derivatives and other financial instruments. What we need also is more VW Golf 1.4 TSI and far fewer Audi R8’s and we also need better control over those using them. If we can achieve this (which will need intergovernmental, international agreements and controls) we can look forward to derivatives actually helping, rather than endangering economies and nations. After that all we need to ensure is that people like us stop wanting today what we can’t afford until tomorrow. 

Chris Parry is a Senior Lecturer in Financial Services at the Cardiff School of Management at the University of Wales Institute, Cardiff (UWIC).

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