October 20th, 2011
Most people have no idea that Wall Street has become a gigantic financial casino. The big Wall Street banks are making tens of billions of dollars a year in the derivatives market, and nobody in the financial community wants the party to end. The word “derivatives” sounds complicated and technical, but understanding them is really not that hard. A derivative is essentially a fancy way of saying that a bet has been made. Originally, these bets were designed to hedge risk, but today the derivatives market has mushroomed into a mountain of speculation unlike anything the world has ever seen before. Estimates of the notional value of the worldwide derivatives market go from $600 trillion all the way up to $1.5 quadrillion. Keep in mind that the GDP of the entire world is only somewhere in the neighborhood of $65 trillion. The danger to the global financial system posed by derivatives is so great that Warren Buffet once called them “financial weapons of mass destruction”. For now, the financial powers that be are trying to keep the casino rolling, but it is inevitable that at some point this entire mess is going to come crashing down. When it does, we are going to be facing a derivatives crisis that really could destroy the entire global financial system.
The Coming Derivatives Crisis That Could Destroy The Entire Global Financial System
How Derivatives Blows Up
A derivative is an instrument that allows one to make leveraged bets on something else – the underlying.
Let’s take a look at a stock call option. Here we are making a bet on how the price of a particular stock (the underlying) moves. Let’s say our call option will provide a payoff if the price of the stock is over $100 in one year. The amount of the payoff is based on the price of the stock in one year. The current price of the stock is $90.
How do you price the call option for this example?
Call Option Price = ((Average Price in 1 Year Given it is Over $100) minus $100) x (Probability the Price is Over $100) x (Discount 1yr using Risk-Free Rate)
To get this price you could just run a simulation of stock movement. Do 10,000 simulations, take the average of all prices over $100 and calculate how many of the 10,000 simulations had a price of over $100 at the end of the year. For the risk-free rate just take the 1yr Treasury rate (Is it really risk-free? That’s another issue).
To run a simulation you just need the stock volatility. This assumes no dividends.
You can use the Black-Scholes formula to calculate this price too, but that is more of a black-box.
Where does the blow up part come in?
All simulations and the Black-Scholes formula assume that people act independently like little particles bouncing around (Brownian motion or Wiener process). In other words, there isn’t a shock event that causes everyone to act in unison. So the results significantly underestimate tail risk by an order of 10 to 20 times. That 1 in 200 year event is really a 1 in 20 year event.
In normal trading, the tail risk problem isn’t an issue. However, once every 10 to 20 years things will blow up.
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