An Easily Understandable Explanation of Derivative Markets

By PravdaSeeker
Surfing the Apocalypse

Heidi is the proprietor of a bar in Detroit. She realizes that virtually all of her customers are unemployed alcoholics and, as such, can no longer afford to patronize her bar. To solve this problem, she comes up with a new marketing plan that allows her customers to drink now, but pay later. She keeps track of the drinks consumed in a ledger.

Word gets around about Heidi’s “drink now, pay later” marketing strategy and, as a result, increasing numbers of customers flood into Heidi’s bar. Soon she has the largest sales volume for any bar in Detroit.

By providing her customers freedom from immediate payment demands, Heidi gets no resistance when, at regular intervals, she substantially increases her prices for wine and beer, the most consumed beverages. Consequently, Heidi’s gross sales volume increases massively.

A young and dynamic Vice President at the local bank recognizes that these customer debts constitute valuable future assets, and increases Heidi’s borrowing limit. He sees no reason for any undue concern, since he has the debts of the unemployed alcoholics as collateral.

At the bank’s corporate headquarters, expert traders transform these customer loans into DRINKBONDS, ALKIBONDS and PUKEBONDS. These Securities are then bundled and traded on international security markets. Naive investors don’t really understand that the securities being sold to them as AAA secured bonds are really the debts of unemployed alcoholics. Nevertheless, the bond prices continuously climb, and the securities soon become the hottest-selling items for some of the nation’s leading brokerage houses.

One day, even though the bond prices are still climbing, a risk manager at the original local bank decides that the time has come to demand payment on the debts incurred by the drinkers at Heidi’s bar. He so informs Heidi.

Heidi then demands payment from her alcoholic patrons, but being unemployed alcoholics they cannot pay back their drinking debts. Since Heidi cannot fulfill her loan obligations, she is forced into bankruptcy. The bar closes and the eleven employees lose their jobs.

Overnight, DRINKBONDS, ALKIBONDS and PUKEBONDS drop in price by 90%. The collapsed bond asset value destroys the bank’s liquidity and prevents it from issuing new loans, thus freezing credit and economic activity in the community.

The suppliers of Heidi’s bar had granted her generous payment extensions and had invested their firms’ pension funds in the various BOND securities. They find they are now faced with not only having to write off her bad debt but also with losing over 90% of the presumed value of the bonds. Her wine supplier claims bankruptcy, closing the doors on a family business that had endured for three generations, and her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 150 workers.

Fortunately, the bank, the brokerage houses and their respective executives are saved and bailed out by a multi-billion dollar, no-strings attached cash infusion from their cronies in Government. The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-drinkers who have never been in Heidi’s bar.

Now, do we all understand?

Well, there you have it folks… pretty easy to GRASP the concept now, eh?

2 responses to “An Easily Understandable Explanation of Derivative Markets

  1. It’s even easier than that, for me. It’s not a long story at all.

    Invest your hard-earned money that is losing value sitting idle, anyway, in a contract that promises to pay you if the workers from a neighboring village fail to meet their performance goals.

    Your Brokers have inside information that your neighbors are idiots and WILL fail to meet their goals — just look at these numbers — so rest assured that the contract you sign is guaranteed to pay you 100 times what you invest RIGHT NOW at the designated time the day after tomorrow.

    Your Brokers then go to your neighboring village and tell them the same story they just told YOU about THEM, but about you: you’re idiots, you can’t possibly succeed, just look at these numbers, rest assured that the contract you sign is guaranteed to pay you 1000 times what you invest RIGHT NOW at the designated time, tomorrow.

    Your Brokers wave the cash they just soaked both of your villages for and use it as proof that, two days from now, both villages will become wholely owned subsidiaries of our Brokers’ bank, making the assets of the two villages and all the future work done there, the property of said bank.

    Your Brokers use your cash to collateralize a loan based solely on their ingenuity and the guaranteed future labor of both of your villages, combined. They obtain a loan for 500 times the cash they provide, cash the loan check at a second bank, and dump their funds in gold-backed securities in a country that guarantees their anonymity and the security of their investment.

    The next day, all the cash dries up first in one village, then another, and the money trail ends in Switzerland.

    Want to fight back now? Don’t work for cash, work for hard commodities that you need to survive. Then come up with your own currency and start the whole process over again.

  2. Both the post and the first comment are bloody excellent clarifications, well done!

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