ralfy wrote:In any event, I think anyone will have a lot of difficulty explaining how present credit levels can be backed up by physical assets.
I realize this is an old conversation but thought I'd just chime in and try for a simple definition.
Derivatives are contracts whose value is
derived from an underlying asset but which otherwise have no connection or claim on that asset.
Let's say you loan someone money @10% to buy a car. You keep the title as security, it's a securitized loan.
But you are worried rates may rise. So to hedge your risk that the cost of money might rise above say 8%, you make a contract with a different party who will pay you some amount if rates rise. In return you pay some set fee every month or whatever. That person has no claim on the car directly, no involvement in the original loan whatsoever, the whole contract is derived from an interest rate benchmark. it's insurance. It's a bet.
Whatever you call it, it's not backed by anything except the contract. The reason there can be such a ridiculous total value of 1,600T or whatever is these bets can be made on anything, oil futures, the weather, stock options exchange rates. And they can all be stacked one atop the other, the car loan can be hedged, swapped, futured... then those contracts can be used in trances to be combined or split and hedged again until nothing recognizable remains of the original transaction. Who would even know how many bets that one car loan is the focus of?
I think that's how it works
Read The Big Short by Michael Lewis, really great book about how the subprime banks lost their ass selling swaps.