Derivative Markets explained for the layman.
An Easily Understandable Explanation of Derivative Markets:
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 new marketing plan that allows her customers to drink now,
but pay later. She keeps track of the drinks consumed on a ledger
(thereby granting the customers loans.
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 banks 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 having to write off her
bad
debt and with losing over 90% of the presumed value of the bonds. Her
wine
supplier also claims bankruptcy, closing the doors on a family business
that had endured for three generations, her beer supplier is taken over
by
a competitor, who immediately closes the local plant and lays off 150
workers.
Fortunately though, 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 the Government. The funds required for this
bailout are obtained by new taxes levied on employed, middle-class,
non-drinkers.
Now, do you understand?
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