Financial Derivatives 101

I'm no 'HooHa' but let's say that I'm also no Banker Extrordinaire. I got no MBA. I'm no resident expert on the financial systems of the world. I try to stomach through a medicinal dose of conspiracy theory videos about the banking system. The only credentials I hold are those of an Industrial Designer, and I'm afraid they've expired from lack of use.

If only that were so for the debt.

All that said, what I am is a mathematician.

I do math problems in my head that I apply to everything around me when I'm walking down the street. I read books about Math. I have mathematical diagrams on my walls in the office representing problems that I am currently solving. As a programmer I do math for work.

The only math degree I hold is in the Virtual Marv Levich College Emeritus, and that and a quarter will get me a gumball, and maybe a client or two if I wear the right clothes on the way to the machine.

Financial Derivatives

In my mind financial derivatives are potentially the single most hubristic form of predatory capitalism that there is. And for that reason, I am compelled to provide as best I can an allegorical bridge for folks to climb across that does not involve knowing high math. I think people owe it to themselves to understand this one.

Shall we play a game?

Imagine that you and your perfect mate decide to get busy having some chillins. Brown Chicken Brown Cow and all that.

From the time of that little zygote's conception onward, there are things we will be able to measure about your child.

We can analyze their DNA to know what genes are there that have potential to be expressed. We can do a speak and voice analysis of you and your mate's speech patterns and the things you say to one another and how you talk to one another to understand things about the environment that your baby will grow up in. We can study what you do for a living, what your mate does, where you live, how much money you make, and who your relatives are respectively to better get a sense of the earning potential of your baby.

The minute this zygote turns 18, she will open on the public market.

Just so we have something real to play with, let's give this person some traits.

Allow me to introduce 'Ana Castillo'

Ana is the daughter of a first generation immigrant family that came to the live in the United States when her mother was pregnant with her. Her parents were teaching at the University Level (Mother: MBA, Father: Political Science and International Law) and are from Columbia. They came under persecution after a regime change for having family connections with the wrong political circles and felt, for their safety and that of their children, that they had to move.

Because of their connections in the states, Ana's parents were both offered positions teaching at different small Liberal Arts colleges in Boston. The family of 4 (Ana has an older brother) is worth 550,000 and including the income that both made from outside consulting, had a yearly family income last year of $214,000. Ana's mother's family has a history of mental health issues (suicides on both sides of her family tree). Ana's father's family has a connection to the Columbian banking systems.

Ana's trading will start at a net worth of $120,000. will become public the minute she turns 18 with an initial net worth of $120,000. The sources are mostly gifts from family, and as Ana will not have worked a day of her life when the trading starts. She has performed moderately well (85th percentile) in school, her SAT scores average at 1092, and her ACT scores at around 28. Her IQ is 117. Her strengths are language and sciences, and her weakness are math, writing and logic problems. She participates in no sports or extracurricular activities. She has a few very close friends and is relatively shy when compared to her peers. She says she wants to become a psychologist, but her parents want her to think more practically and more in terms of her future. She has had suitors but never a boyfriend.

Let the bidding begin.

In an older and more traditional market (pre-derivatives), I would look at her parents, her numbers, her performance in the past, trends in the market, and possibly include her as part of my portfolio. Given the picture I have painted here, I would not be feeling particularly bullish or bearish about her. I would approach this investment conservatively and might only really want to increase my investment in her if she performed well over time.

Is Ana feeling objectified? Yes. But at least in this scenario, she has a power in her own right (although objectified) to assert herself in the world and make something happen. Some might find fault with this analogy but remember that corporations are given the same status as people in the United States.

Enter Derivatives.

Now let's say I have an enormous database of all of the 'Human Options' that are available in the current market. I can extrapolate the 'meta data' and have programs which analyze it well for me.

Let's say, as an investor, I have noticed a correlation among children of first generation immigrants who: a) come from money/financial connections, b) are coming from Latin American countries, c) are female and d) have older siblings who are performing well. The correlation is that after a small dip between the ages of 22 and 24, the value of their net worth doubles between the ages of 25 and 28.

Ana is no longer an Object.

She now represents a trend in a population of many individuals just like her. Instead of investing directly in Ana or people like Ana, a person investing in a derivative would invest in that correlation for people in her population to perform well between the years of 25 and 28. A derivative derives it's value by betting that this correlation will continue to exist. Instead of betting on actual businesses or corporations or (in this case) people, it's hedges a bet on the existence of mathematical phenomenon among a variety of players.

So instead of having to invest in one person, which can be seen as risky because what if they get into an accident or become ill or whatnot, you cut your 'risk' and instead bet on the fact that first generation Latin American women living in the states with successful older siblings will double their net worth between the ages of 25 and 28.

Why is this attractive? Because when you win, you win BIG. Unfortunately, when you loose, it's also BIG. Derivatives are volatile because phenomenons and behavior can often shift much more rapidly and on a MUCH grander scale than 'real' wealth can. Instead of being based on 'real' wealth they are based on the willingness of the banks to continue to insure 'real money' to 'real people' in the 'real world' based on the phenomenon or correlation you have discovered.

Why is that so wrong?

In the example above, the derivative is less risky. What could possibly happen to phenomenologically change the behavior of the population of people that Ana represents in a short amount of time?

If you were investing in derivatives predicting the price of Almonds in California, your investment would be a bet hedged against a bank's willingness to insure and make loans based on these specific 'futures' for the price of almonds.

Let's say there is a sudden hard freeze at the wrong time of year or a severe Monsanto Round Up-inducced decimation of the bee population. Your derivative doesn't simply decrease in value, it becomes completely worthless.

In fact, if you were Monsanto and could see something like that coming, it might be worth it to create a Derivative based on your own derived 'futures' for Almonds, or to invest in the 'futures' of a new product that has not yet hit the market: a nanobot army of mechanized bees. In fact, I think they are past the prototyping phase...

In a similar vein, someone like Warren Buffet might invest in a 'future' called the stock market crashing in 2014 since his well respected "Warren Buffet Indicator" is predicting it these days... Another Derivative might base itself on the scarcity of water.

See what I mean, Vern?

Not to mention that Derivatives are not regulated in the same way that normal investments have been, and by some digital slight of economic voodoo, have allowed their collective value to FAR exceed the net value of all goods and services produced globally. As Peter Siris says:

  • The total value of all goods and services produced globally is estimated at $70 trillion. The value of all the financial assets in the world is about $150 trillion. The value of all the derivatives in the world is about $700 trillion.
  • That means financial institutions are betting 10 times the value of the world's economic output and more than four times the value of the world's assets on these insurance policies.

That's right. Derivatives are worth 10 times more at any given moment than the entire world's stock of goods and the total value of global services being performed.

Holy Mother of God

Yeah. Exactly.

The scary thing is that many folks have investments that include derivatives, and are completely unaware.

What can you do to protect yourself? Simple. Divest in the market, and invest in your community.

This concludes Financial Derivatives 101. Over and out.