The recipients of the massive bail-outs and buy-outs administered by the USA government have all been in the same sector of the USA economy. the financial sector. Why is the financial sector the privileged sector? The answer is simple and yet staggering. In a word, it is derivatives. Warren Buffet described derivatives as, "Weapons of Economic Destruction", and in the following paragraphs, I'll discuss briefly what a derivative is and then place most of the attention on why they have become the "weapons of economic destruction". What is a derivative? Per Wikipedia, derivatives are "financial contracts, whose values are derived from the value of something else.The underlying value on which a derivative is based can be an asset (e.G., commodities, stocks, residential mortgages, commercial real estate, loans, bonds), a stock index, weather conditions, or other items. A derivative enables investors to take rather large positions (a.K.A.A gamble) in a given market for a relatively small amount of capital, and with such leverage comes substantial profit, if the gamble is correct, or loss, if the gamble is wrong. With a derivative, one investor wins and one investor loses. Why are derivatives "weapons of economic destruction"? The answer has two reasons, the first being their lack of transparency. Those who invest through derivatives are not required to disclose information regarding counterparties to the regulators. With this shroud of anonymity around the derivatives market, investors, government agencies, and private agencies can not ascertain the risk assumed by individual companies, banks, or the entire financial system. The second reason why derivatives are so dangerous is their massive market size. The typical volatility which affects this market ranges from 2% to 5%, so on any given day, the losses from this one quadrillion USD market can approximate US$37 trillion dollars! The total market value of all equities on the planet is about US$31 trillion, so derivatives have the power to destroy all of the known world's equities in a single day. Now that we understand the magnitude and destructive power of the derivatives market, we can likewise understand the reason why the financial sector of the USA has received, in bail-out money from the USA government, more money in terms of GDP than was given to pay for World War 1, the Korean War, the Vietnam War, the Gulf War, and Operation Iraqi Freedom COMBINED. The financial sector has become, as they say, "too big to fail", and thus the reason why the financial sector has received trillions of dollars worth of US tax payer funded bail-out money.
Saturday, September 1, 2012
Investment Newsletter Summary - Derivatives and Why They Matter
The recipients of the massive bail-outs and buy-outs administered by the USA government have all been in the same sector of the USA economy. the financial sector. Why is the financial sector the privileged sector? The answer is simple and yet staggering. In a word, it is derivatives. Warren Buffet described derivatives as, "Weapons of Economic Destruction", and in the following paragraphs, I'll discuss briefly what a derivative is and then place most of the attention on why they have become the "weapons of economic destruction". What is a derivative? Per Wikipedia, derivatives are "financial contracts, whose values are derived from the value of something else.The underlying value on which a derivative is based can be an asset (e.G., commodities, stocks, residential mortgages, commercial real estate, loans, bonds), a stock index, weather conditions, or other items. A derivative enables investors to take rather large positions (a.K.A.A gamble) in a given market for a relatively small amount of capital, and with such leverage comes substantial profit, if the gamble is correct, or loss, if the gamble is wrong. With a derivative, one investor wins and one investor loses. Why are derivatives "weapons of economic destruction"? The answer has two reasons, the first being their lack of transparency. Those who invest through derivatives are not required to disclose information regarding counterparties to the regulators. With this shroud of anonymity around the derivatives market, investors, government agencies, and private agencies can not ascertain the risk assumed by individual companies, banks, or the entire financial system. The second reason why derivatives are so dangerous is their massive market size. The typical volatility which affects this market ranges from 2% to 5%, so on any given day, the losses from this one quadrillion USD market can approximate US$37 trillion dollars! The total market value of all equities on the planet is about US$31 trillion, so derivatives have the power to destroy all of the known world's equities in a single day. Now that we understand the magnitude and destructive power of the derivatives market, we can likewise understand the reason why the financial sector of the USA has received, in bail-out money from the USA government, more money in terms of GDP than was given to pay for World War 1, the Korean War, the Vietnam War, the Gulf War, and Operation Iraqi Freedom COMBINED. The financial sector has become, as they say, "too big to fail", and thus the reason why the financial sector has received trillions of dollars worth of US tax payer funded bail-out money.
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