Credit Default SwapsFollow

Did you even listen to the interview?

You did, right? Why don't you explain to us what you learned from it and the functioning of credit derivatives in the modern market.

I mean you're no longer ignorant, right? You now have an understanding of exactly what's going on, and can assess where the problem was and what went wrong, right?

The floor is yours:

Actually, the evolutionary reasoning for the development of the menstrual cycle in higher primates is still not completely understood. We know that the uterine lining is shed, but we don't know why it ended up like that. (The current popular hypothesis is that it cleans out and prevents bacterial infections.)

This situation is much the same. The more you dig into it, the less you discover you understand about it.

So your solution is wait until it all goes tits up and say "I told you so"?

I've been doing that with you and you keep telling me i won't understand!!!

OMG i'm turning into Anna....

Edited, Apr 4th 2008 10:27am by tarv

I've been doing that with you and you keep telling me i won't understand!!!

Ok, fine, let's see how far we get.

First let's start with simple derivatives like option calls and puts which are much less complicated than credit instruments, but still something most people don't understand very well.

I own a stock. I'm worried it'll go down, but the risk isn't high enough that I want to sell it at no profit. What I do is hedge by writing a call option on the stock I own and selling it to you. You buy from me an option to buy from me the stock at it's current price (or any one we agree on, but for simplicities sake..) at any point in the next six months. I make money from you paying me for the option to do this.

With me so far?

Ok. good.

So let's set some parameters. I own 1000 shares of Allahstock which currently trades at $100 a share. You think there is a good chance Allahstock will increase in value at some point in the next six months. You have various ways to try to make money from your thinking, but let's just talk about two.

You can buy Allahstock from me for the current value of $100 share. This is something most people understand. If you have $100,000 you can buy all of my shares, and if the price increases, sell those shares for a profit. Let's say that you only have $1000 to invest, however. The return on the increase in value you predict for Allahstock might not be very great because you'd only be able to purchase 10 shares. You'd like to leverage your investment, and control all of my shares of Allahstock without actually owning them. This is why you'd buy the call I write.

You pay me a premium for the right to buy all of my shares of Allahstock at any point in the next six months for the current price of $100. Let's say the premium is $1000. You give me your $1000 which I keep as profit, and I give you the right to buy all of my shares for $100,000 at any point in the next six month.

If Allahstock goes to $110 a share in two weeks, you can buy all of my shares and make a $9,000 profit. ($10000 - the $1000 you paid for the option).

Still pretty straightforward?

I thought we had agreed i wouldn't understand and you where going to tell me what you think the solution to the current problem is.

But yeah i'm following so far.

More regulation by government economists is the solution to the current problem, I think pretty much everyone agrees with that at this point.

If people want to have a better understanding of just how complex the real issues at hand are though, I'm more than willing to give it a go.

Anyway back to our options deal.

Conceptually, it's pretty simple so far, I'm willing to give you the option to buy for a certain price, you're willing to pay to control my stocks for a given time frame.

Here's where the tricky part comes in, and will illustrate why I say there isn't really a way to explain in "layman's terms" the current situation.

The primary variable that determines who will make the money on our option deal is the price you pay me for the premium. As an extreme example, if the premium is one cent, you'll almost certainly make money long term as you'd only need to be correct about the stock increasing in value very very rarely to cash in heavily when it did. At the other extreme, if premium to controls the stock was $99,999 it would be almost impossible for you to make money long term because you'd have to be right about the stock increasing in value virtually every time to offset the high cost of the premium relative to just buying the stock from me outright.

If one of us is better at determining what the real fair value of that premium is (that is the value where it's essentially a wash in probability terms of who will make money) that one of us is going to end up with all the money simply by buying the option below fair value or writing it above fair value.

It's currently accepted that it's impossible to perfectly calculate this, but we can get closer and close the better our math is.

Here's one method of determining that value that's used fairly widely.

http://en.wikipedia.org/wiki/Black-Scholes

If one can't understand the math in play, it essentially becomes a matter of faith that fair values determined by a given process are actually fair.

This is, "in laymans terms" the current problem. The systems used to determine fair value of these credit derivatives are flawed in certain ways in that the values for risk have been too low. A cynic might conclude, and this is my feeling, that the risk is low because government bailout is built into the algorithm.

The math in question for credit derivatives is substantially more complicated that Black-Scholes, and the problem really is in the math, not the conceptual process.

Credit Default Swaps aren't a flawed instrument, their valuation is flawed because of the math.

My whole point here is that if you can't understand that math, having a general understanding of how they're used to distribute risk is useless in terms of understanding what's wrong with them.

But still, understanding the journey that took you to this mental cul-de-sac is worth a lot more than simply giving up before you get there, surely.


Maybe, but the end result is that most people aren't going to understand the situation any better than they did a year ago. They'll just have a firmer grasp that they *really* aren't going to understand it instead of the common perception now, that if someone just explained it to them they could then speak intelligently about it and hold a valid opinion.

You're trying to find a page that does not exist

I think you have to sign up to see that page you're linking m8.

A small step for man, a giant leap for mankind education.

ok all fixed. thanks for that heads up.

I highly doubt it, especially when the people who are supposed to be semi-understanding admit they don't know much at all. It's a case of macro-economics on a scale which no one has dealt with before. Basically we are in uncharted territory right now.


That's a lie, though, because me telling you I don't really understand something I KNOW you don't understand plays a lot better for me than me telling you I intentionally rigged the system to @#%^ you.



Edited, Apr 4th 2008 5:33pm by Smasharoo