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If the derivatives market didn't provide an infinite soak for excess capital, then that money would be forced to go find something "real" to invest in, and the

If the derivatives market didn't provide an infinite soak for excess capital, then that money would be forced to go find something "real" to invest in, and the economic theory TFA talks about might work (money should flow from advanced, low growth, economies, to less developed, higher growth opportunity, markets). As someone who doesn't really understand finance and economics, this is really interesting to me. Doesn't this suggest though that those derivatives markets are really inefficient? ie for them to really appeal to capital that isn't merely hedging, doesn't this mean that they would have to be materially different than their underlying contracts?

rmah 6y ago
I'm speculating, but I suspect marcus_holmes's world view has been shaped by reading the many articles about of the "GIGANTIC SIZE" of various derivatives markets. Those articles almost always use "notional value" of the underlying assets to "size" the derivatives markets. Which is, IMO, pretty misleading. In the simplest terms, a derivative is a security that is derived from some other underlying asset. Typically, they are contracts -- contracts that can be bought and sold on financial markets. For example, a call options contract says "the holder may, at his option, purchase 100 shares of ABC at $250/share on or before 15-Dec-2020". And on the other side, the writer of that contract is obligated to fulfill it if the holder exercises it (but most options contracts expire unexercised). What many articles for the public would say is "that derivative is $25,000 in size!" Except that the contract may be trading at around $0.50/share (or $50). And then they'll multiply it out across all derivatives... thus leading to surprising "conclusions" like "the derivatives market for X is 10 times larger than X itself!" Which is sorta true if you squint hard enough, but mostly not true in terms of all other financial metrics. To circle back, while it is true that there is a huge amount of what many would term "excess capital" sloshing around, I don't think the derivatives market "provide[s] an infinite soak" for it. In reality, a large chunk of it goes into low-risk fixed income instruments such as US Treasuries, other sovereign debt, and AAA-rated corporate bonds.
- marcus_holmes 6y ago
  This is useful. And yes, I probably have an inadequate understanding of the derivatives market (hence going out on a limb). Where I think the problem is, is the disconnect between actual supply/demand of the thing and the gambling about whether the price is going to go up or down. For example, as you say, most option contracts expire unexercised. In the context of TFA, where we're talking about where investment money can go, buying an options contract with no intention of ever actually exercising the option is effectively a complete waste of investment opportunity (compared with, say, building infrastructure in Africa). My point of view is that the derivatives markets in developed economies allows such pointless investments (aka gambling). If there wasn't a derivatives market, this money would be forced to go find something else to invest in. That might be government bonds as you say. Or it might be African infrastructure.

rmah 6y ago

I'm speculating, but I suspect marcus_holmes's world view has been shaped by reading the many articles about of the "GIGANTIC SIZE" of various derivatives markets. Those articles almost always use "notional value" of the underlying assets to "size" the derivatives markets. Which is, IMO, pretty misleading. In the simplest terms, a derivative is a security that is derived from some other underlying asset. Typically, they are contracts -- contracts that can be bought and sold on financial markets. For example, a call options contract says "the holder may, at his option, purchase 100 shares of ABC at $250/share on or before 15-Dec-2020". And on the other side, the writer of that contract is obligated to fulfill it if the holder exercises it (but most options contracts expire unexercised). What many articles for the public would say is "that derivative is $25,000 in size!" Except that the contract may be trading at around $0.50/share (or $50). And then they'll multiply it out across all derivatives... thus leading to surprising "conclusions" like "the derivatives market for X is 10 times larger than X itself!" Which is sorta true if you squint hard enough, but mostly not true in terms of all other financial metrics. To circle back, while it is true that there is a huge amount of what many would term "excess capital" sloshing around, I don't think the derivatives market "provide[s] an infinite soak" for it. In reality, a large chunk of it goes into low-risk fixed income instruments such as US Treasuries, other sovereign debt, and AAA-rated corporate bonds.

marcus_holmes 6y ago
This is useful. And yes, I probably have an inadequate understanding of the derivatives market (hence going out on a limb). Where I think the problem is, is the disconnect between actual supply/demand of the thing and the gambling about whether the price is going to go up or down. For example, as you say, most option contracts expire unexercised. In the context of TFA, where we're talking about where investment money can go, buying an options contract with no intention of ever actually exercising the option is effectively a complete waste of investment opportunity (compared with, say, building infrastructure in Africa). My point of view is that the derivatives markets in developed economies allows such pointless investments (aka gambling). If there wasn't a derivatives market, this money would be forced to go find something else to invest in. That might be government bonds as you say. Or it might be African infrastructure.