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Notional values can not be usefully compared between asset classes. That's why it's so dumb that people keep reporting them in the media. Comparing $1T of CDS t

by bjterry 10y ago

Notional values can not be usefully compared between asset classes. That's why it's so dumb that people keep reporting them in the media. Comparing $1T of CDS to $493T of derivatives is like comparing Fahrenheit numbers to Celsius numbers. Comparing either of those to GDP is like comparing Fahrenheit and Calories.

elif 10y ago
What about comparing it to the world's total debt? that figure is more than double the current debt of the entire world (230T). Does the act of re-packaging that 230T really create an additional 263T in value? And even if so, is that not a hopeless feedback loop?
- ddeck 10y ago
  I'm not sure what comparison you're trying to make. These derivatives are typically used modify the cashflows of those instruments for different issuer/investor preferences. The vast majority (>90%) of that OTC derivative figure is interest rate andFX swaps and the gross market value of those swaps are less than $15 trillion. The aggregate notional principal has also been declining for the last several years. Here's an example trade: I'm a European company and I've determined there's demand for my USD fixed rate bonds in America, but I need EUR to invest in my business and my profits are linked to interest rates so it's less risky for me to pay a floating interest rate. So to reduce my risk, I need to swap the bond cashflows into EUR and the fixed rate payments into floating rate payments. I issue $100 of bonds to US investors, and then I execute a $100 notional fixed-floating FX swap with a bank. That bank then executes a $100 notional fixed-fixed FX swap with another counterparty and a $100 notional (EUR equiv) rate swap with a different counterparty. So we have $300 notional value of OTC swaps and a $100 bond. And if we take out the central counterparty, the three swaps actually net into a single $100 swap.
  - TheOtherHobbes 10y ago
    What happens if any part of the chain breaks?
    - ddeck 10y ago
      Parts of the chain break regularly. Individuals, companies, and even banks go bankrupt. These outcomes are expected and swap agreements are protected by collateral under an ISMA agreement to mitigate the potential losses to counterparties should the other counterparty default. Now it's reasonable to argue about the amount and type of collateral required (which is broadly the topic of the article), but aggregating all of the notional doesn't produce a meaningful number, because it doesn't reflect the underlying risk. Even without the sort of hedging I described, it's impossible to draw any meaningful understanding of the risk from the notional number. Consider the following two contracts: Party A sells $100 protection on a corporate to party B (i.e. CDS) Party A enters a $100 1Y USD interest rate swap with party B, paying floating. If the underlying corporate defaults with no recovery in the first case, it's quite possible party A will owe $100 to party B In the second case, there is a realistic ceiling on what can happen to USD interest rates within the next year. Let's imagine the impossibly unlikely scenario where the fed decided to raise rates to 5% overnight one day after the contract was signed. Even in this situation, the value of the swap (i.e. loss to party A) is still likely only around 5%.
- bjterry 10y ago
  Even writing a $1B loan doesn't create $1B in value. You start with Alice having nothing and Bob having $1B in cash, then you end with Alice having $1B in cash, $1B in debt, and Bob having a $1B loan asset, which nets to $1B in total value. The value it creates is that Alice can spend that cash on an activity that creates greater economic returns. If that $1B allows her to build a factory worth $1.2B, the act of creating the loan has created $200M in value. Derivatives are a financial optimization of this idea. Swaps were created because they have lower transaction costs than other mechanisms. A $1B swap doesn't allow you to build a factory, it just moves some of the risk of your business around at the edges, and so the value created by the swap is correspondingly less than the value created by a loan with an amount equal to the swap's notional principal. If you swap your floating interest rate to a fixed, maybe that means your risk of default is 5% lower so your factory increases in value from $1.2B to $1.26B, even though the notional value of this swap is $1B. Much less than the loan. That's why as ddeck pointed out, the actual market value of swaps is dwarfed by the market value of debts. In case anyone wants to engage with this, I'm not talking about hedge funds here, I'm talking about the point where the financial world bottoms out in the world of physical goods and services. The fact that hedge funds can create returns with swaps is beside my point, and is something that I'm uninterested in discussing.
trhway 10y ago
>Notional values can not be usefully compared between asset classes. it is the same asset class - unsecured put options. Granted some of those CDS and derivatives are bought as real hedge/insurance, the rest [ most ] are just "casino" bets. (It is a hedge/insurance if the buyer of the put option owns the interest in the underlying asset and the amount of that put option isn't larger than the amount of the interest owned by the buyer in that underlying asset.) >Comparing $1T of CDS to $493T of derivatives is like comparing Fahrenheit numbers to Celsius numbers. nope. For the reason described above. >Comparing either of those to GDP is like comparing Fahrenheit and Calories. nope again. Because US GDP was significantly larger, it was able to pay off those put options in 2008 (on behalf of AIG and the others well connected ... err ... system critical)
- hueving 10y ago
  Your definition of "casino" bet is bogus. Requiring an investment to be a hedge against another investment to not be considered a bet is arbitrary and nonsensical. Every investment is a bet something will or will not happen (e.g. bonds are a bet the issuer will pay).
  - trhway 10y ago
    >Requiring an investment to be a hedge against another investment to not be considered a bet not to be considered a "casino" bet. You added generalizations which clearly weren't in my post. I was talking about buying put options (CDS, derivatives) without having comparable exposure to the risks in the underlying assets. >is arbitrary and nonsensical. Having or not such mentioned above exposure defines clearly opposite set of interests and behaviors in the market, and thus provides a significant and valid characteristic to separate those 2 classes of investors and investments. People who buy insurance for their homes have completely different interests from the people who would buy a CDS for the real estate of the town without owning any real estate in the town - the later would profit handsomely if the town is completely burned by a fire while no fires during contract period of the CDS would mean total loss of their bet. Seems like a casino bet, only on big fire event instead of a 36 black.

by bjterry 10y ago

elif 10y ago

What about comparing it to the world's total debt? that figure is more than double the current debt of the entire world (230T). Does the act of re-packaging that 230T really create an additional 263T in value? And even if so, is that not a hopeless feedback loop?

ddeck 10y ago
I'm not sure what comparison you're trying to make. These derivatives are typically used modify the cashflows of those instruments for different issuer/investor preferences. The vast majority (>90%) of that OTC derivative figure is interest rate andFX swaps and the gross market value of those swaps are less than $15 trillion. The aggregate notional principal has also been declining for the last several years. Here's an example trade: I'm a European company and I've determined there's demand for my USD fixed rate bonds in America, but I need EUR to invest in my business and my profits are linked to interest rates so it's less risky for me to pay a floating interest rate. So to reduce my risk, I need to swap the bond cashflows into EUR and the fixed rate payments into floating rate payments. I issue $100 of bonds to US investors, and then I execute a $100 notional fixed-floating FX swap with a bank. That bank then executes a $100 notional fixed-fixed FX swap with another counterparty and a $100 notional (EUR equiv) rate swap with a different counterparty. So we have $300 notional value of OTC swaps and a $100 bond. And if we take out the central counterparty, the three swaps actually net into a single $100 swap.
- TheOtherHobbes 10y ago
  What happens if any part of the chain breaks?
  - ddeck 10y ago
    Parts of the chain break regularly. Individuals, companies, and even banks go bankrupt. These outcomes are expected and swap agreements are protected by collateral under an ISMA agreement to mitigate the potential losses to counterparties should the other counterparty default. Now it's reasonable to argue about the amount and type of collateral required (which is broadly the topic of the article), but aggregating all of the notional doesn't produce a meaningful number, because it doesn't reflect the underlying risk. Even without the sort of hedging I described, it's impossible to draw any meaningful understanding of the risk from the notional number. Consider the following two contracts: Party A sells $100 protection on a corporate to party B (i.e. CDS) Party A enters a $100 1Y USD interest rate swap with party B, paying floating. If the underlying corporate defaults with no recovery in the first case, it's quite possible party A will owe $100 to party B In the second case, there is a realistic ceiling on what can happen to USD interest rates within the next year. Let's imagine the impossibly unlikely scenario where the fed decided to raise rates to 5% overnight one day after the contract was signed. Even in this situation, the value of the swap (i.e. loss to party A) is still likely only around 5%.
bjterry 10y ago
Even writing a $1B loan doesn't create $1B in value. You start with Alice having nothing and Bob having $1B in cash, then you end with Alice having $1B in cash, $1B in debt, and Bob having a $1B loan asset, which nets to $1B in total value. The value it creates is that Alice can spend that cash on an activity that creates greater economic returns. If that $1B allows her to build a factory worth $1.2B, the act of creating the loan has created $200M in value. Derivatives are a financial optimization of this idea. Swaps were created because they have lower transaction costs than other mechanisms. A $1B swap doesn't allow you to build a factory, it just moves some of the risk of your business around at the edges, and so the value created by the swap is correspondingly less than the value created by a loan with an amount equal to the swap's notional principal. If you swap your floating interest rate to a fixed, maybe that means your risk of default is 5% lower so your factory increases in value from $1.2B to $1.26B, even though the notional value of this swap is $1B. Much less than the loan. That's why as ddeck pointed out, the actual market value of swaps is dwarfed by the market value of debts. In case anyone wants to engage with this, I'm not talking about hedge funds here, I'm talking about the point where the financial world bottoms out in the world of physical goods and services. The fact that hedge funds can create returns with swaps is beside my point, and is something that I'm uninterested in discussing.

trhway 10y ago

>Notional values can not be usefully compared between asset classes. it is the same asset class - unsecured put options. Granted some of those CDS and derivatives are bought as real hedge/insurance, the rest [ most ] are just "casino" bets. (It is a hedge/insurance if the buyer of the put option owns the interest in the underlying asset and the amount of that put option isn't larger than the amount of the interest owned by the buyer in that underlying asset.) >Comparing $1T of CDS to $493T of derivatives is like comparing Fahrenheit numbers to Celsius numbers. nope. For the reason described above. >Comparing either of those to GDP is like comparing Fahrenheit and Calories. nope again. Because US GDP was significantly larger, it was able to pay off those put options in 2008 (on behalf of AIG and the others well connected ... err ... system critical)

hueving 10y ago
Your definition of "casino" bet is bogus. Requiring an investment to be a hedge against another investment to not be considered a bet is arbitrary and nonsensical. Every investment is a bet something will or will not happen (e.g. bonds are a bet the issuer will pay).
- trhway 10y ago
  >Requiring an investment to be a hedge against another investment to not be considered a bet not to be considered a "casino" bet. You added generalizations which clearly weren't in my post. I was talking about buying put options (CDS, derivatives) without having comparable exposure to the risks in the underlying assets. >is arbitrary and nonsensical. Having or not such mentioned above exposure defines clearly opposite set of interests and behaviors in the market, and thus provides a significant and valid characteristic to separate those 2 classes of investors and investments. People who buy insurance for their homes have completely different interests from the people who would buy a CDS for the real estate of the town without owning any real estate in the town - the later would profit handsomely if the town is completely burned by a fire while no fires during contract period of the CDS would mean total loss of their bet. Seems like a casino bet, only on big fire event instead of a 36 black.