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My own understanding of derivatives is very weak, but could someone extend this example to explain what the resulting state would be in this chain? Simplifying

My own understanding of derivatives is very weak, but could someone extend this example to explain what the resulting state would be in this chain? Simplifying a little, a->b->c->a (a loop), where -> is "owes $1000". So party A dies, leaving B in the hole, right? This seems like a recipe for massive implosion, an unstable system ala a mountain of sand. Destabilize one grain, somewhere, and you get an avalanche.

byrneseyeview 19y ago
It depends. When Party A started talking to his broker about getting into the derivatives market, his broker might have said "And what do you do in the event that you're solvent, but dead?" And Party A would get in touch with his lawyer, and see to it that in the event of his death, his assets were liquidated and his debts repaid. Sure, it sounds tenuous. On the other hand, our financial system has the same risk -- without the finance -- because we rely on people to do things in the future that they may not be able to do. Imagine a similar market, but without the derivatives: one guy commissions someone to paint his portrait over the next year, the portrait-painter uses the portrait-money he's getting to pay someone to fix up his house, the house-fixer pays to give his kid piano lessons, etc. Again, a single death or default can break the chain, and the 'notional value' here is the value of all future promises made by all parties -- could be larger than the GDP, though the notional value won't get too high unless you have multiple layers of subcontractors. Any time people get comfortable making a promise they can only keep if promises to them are kept, you will be able to calculate a scary notional value for these promises, and argue that we're all betting with vastly more than we own. But everyone who makes a promise -- whether to pay $80 for a barrel of oil next June or to finish debugging next week -- implicitly accepts that there is a chance of default, and expects their counterparties to factor this in. Somehow, despite giant chains of subcontracted promises, our economy has survived. I think it will keep surviving. I think derivatives are not so much a new promises as a way to formalize promises. We might be making more promises than we used to, but we're probably just measuring them better.

byrneseyeview 19y ago

It depends. When Party A started talking to his broker about getting into the derivatives market, his broker might have said "And what do you do in the event that you're solvent, but dead?" And Party A would get in touch with his lawyer, and see to it that in the event of his death, his assets were liquidated and his debts repaid. Sure, it sounds tenuous. On the other hand, our financial system has the same risk -- without the finance -- because we rely on people to do things in the future that they may not be able to do. Imagine a similar market, but without the derivatives: one guy commissions someone to paint his portrait over the next year, the portrait-painter uses the portrait-money he's getting to pay someone to fix up his house, the house-fixer pays to give his kid piano lessons, etc. Again, a single death or default can break the chain, and the 'notional value' here is the value of all future promises made by all parties -- could be larger than the GDP, though the notional value won't get too high unless you have multiple layers of subcontractors. Any time people get comfortable making a promise they can only keep if promises to them are kept, you will be able to calculate a scary notional value for these promises, and argue that we're all betting with vastly more than we own. But everyone who makes a promise -- whether to pay $80 for a barrel of oil next June or to finish debugging next week -- implicitly accepts that there is a chance of default, and expects their counterparties to factor this in. Somehow, despite giant chains of subcontracted promises, our economy has survived. I think it will keep surviving. I think derivatives are not so much a new promises as a way to formalize promises. We might be making more promises than we used to, but we're probably just measuring them better.