These type of contract use banks to protect from different type of risk, interest rate risk, currency risk etc... Can somebody explain me how these works in practice?
Esuric:Why do you use useless jargon like "nominal" and "real" interest rates? They're meaningless, no one knows the true level of inflation, nor do they know the real rate of interest. Since this information is nonexistent, the Fisher effect should be ignored. There's the market rate of interest, which is seen, and then there's the natural rate of interest, which, like the real rate of interest, is unknown.
Yes men this is the true natural rate of interest that's the most important thing. Problem is that people don't know that interest rates are prices like every other prices. Who can tell us how big is inflation rate?... Nobody, and because of that "nominal" and "real" interest rates are useless information.
Interest rate swap - usually a company has a lot of debt. Some/all of the interest paid on this debt varies with changing interest rates. For example, say a company has $2million in debt, and pays interest at LIBOR + 2% (LIBOR is London's central bank's interest rate). So at one point, they may be paying 3% interest, but there is a risk that the rate will go up. Companies want to eliminate this risk. It is usually not to make/save money (speculation) as much as stabalizing the rate (hedging), so they use a swap to keep a steady interest rate.
This is done with a contract with a bank. Basically the terms are (using made up numbers as an example)
The company will always pay the bank at an interest rate of 3%, while the bank will always pay the company at the changing interest rate (say LIBOR + 2%)
Basically it is such that if the interest rate never changes, neither party loses/gains money. If the interest rate rises, then the company made a good move, because it still pays the lower rate. If the interest rate falls, then the company ends up paying more than they would have to absent the contract. But usually it was not used for speculation, so they still have the benefit of stable payments for forecasting purposes.
Currency swaps are a little bit more complicated but similar. Basically a company who holds a lot of foreign currency will enter a contract where a bank will take on the risk of changing currency exchange rates, while the company will be able to exchange at a locked in rate.
Anyone - please correct me if I am wrong, but I believe that is how they are used
And do you know maybe something more about financial derivatives(futures, options...)? What is necessary in one country to do, to enable and start trading whit these type of securities? Is the regulation problem or something else?
Futures - a contract that says person A will buy commodity X at price Y from person B on a set date in the future. Used for hedging or for speculating. For example if I am a cereal company, I might lock in the price I will pay for grain in the future, so I do not have to worry about the price increasing in between now and then. For speculating, if I believe the price will go up, I could lock in a lower price, then in the future I would buy at the lower locked price and sell at the actual price.
Forwards are basically the same thing, with a few small differences.
Options - gives person A the right (but not obligation) to buy shares of a specified stock from B at a specified price up until a certain expiration date in the future. For example, if MSFT is trading at $50, there may be an option of $55 that expires in 1 month. You pay a fee for the option to buy 100 shares of MSFT at $55 at any point in the next month. Obviously you would only exercise the option (actually buy the shares at $55 each) if the actual price goes above $55. So if the real price goes to $60, you would be able to buy 100 shares at $55 each, and then sell them for $60 each, making $500.
I don't know what the second part of your question means.
A swap is essentially just a bet. It's a gamble.
Some liken swaps (e.g., credit default swaps) to insurance policies. But there are some important principles of sound insurance that swaps neglect, perhaps the most important of which is "insurable interest." Anyone (within reason) can buy a "swap," essentially placing a bet that company XYZ will (or perhaps will not) default on some portion of their corporate debt.
For instance, I might buy CDS against AIG. If AIG goes bankrupt and defaults on their debts, then I get paid. Obviously the problem is: I have zero interest in AIG's profitability or bankruptcy, whereas in a true insurance policy I must show a real interest in order to become insured. Because people or companies having no interest in the defaults are able to buy these products, the result is that the underwriter may be obligated to pay out multiples.
Like, if I took out a life insurance policy against you. And so did everyone else on Mises.org. The insurer would be on the hook for hundreds of times the actual risk of economic loss, in your case, a lifetime of earnings.
Now, multiply that by a trillion.
Also, many of these products were highly leveraged, which exacerbates the problem by exposing the "insurer" to 10-fold or 30-fold more risk...
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David Z
"The issue is always the same, the government or the market. There is no third solution."
If one country don't have these type of instruments, what is necessary to do in that country to bring these instrument to the market?
nermin:If one country don't have these type of instruments, what is necessary to do in that country to bring these instrument to the market?
Swap contracts are profitable because of the Federal Reserve interest rate subsidy, keeping real interest rates negative.
For example, corporation A agrees to pay bank B the Fed Funds Rate plus a fee. Bank B agrees to pay corporation A a fixed interest rate for a year.
Bank B then hedges by short selling a 1 year bond and investing the profits at the Fed Funds Rate. The bank makes a guaranteed riskless profit.
The corporation benefits, because they convert an uncertain risk (Fed Funds Rate) to a certain risk (fixed interest rate). This makes it easier for the corporation to plan its expenses for the next year.
The only reason this trade is profitable to both parties is that the Federal Reserve keeps real interest rates negative. The bank may lend/borrow at the Fed Funds Rate, but the corporation cannot. The corporation is forced to use a bank if management wants to hedge its interest rate risk.
I have my own blog at FSK's Guide to Reality. Let me know if you like it.
fsk:Swap contracts are profitable because of the Federal Reserve interest rate subsidy, keeping real interest rates negative.
How can interest rates be negative? Do you try to tell my that federal founds rate is negative? I can believe that fed funds rate can be negative but market interest rate, i thing can't be negative because, investments were be with a negative rate of return.
Nominal interest rates cannot fall below zero, because people would hold cash instead.
The real interest rate equals the nominal interest rate minus the inflation rate.
If the Fed Funds Rate is 0.25% but the inflation rate is 10.25%, then real interest rates are negative 10%.
Using the above example, if you borrow $1B for a year at 0.25%, you're receiving a State subsidy of $100M. In a year, you have to repay $1.0025B, but inflation means the purchasing power it represents is approximately $900M.
You borrow $1B, build a factory, and then repay with devalued money. This makes borrowing profitable and causes boom/bust cycles.
fsk: Nominal interest rates cannot fall below zero, because people would hold cash instead. The real interest rate equals the nominal interest rate minus the inflation rate. If the Fed Funds Rate is 0.25% but the inflation rate is 10.25%, then real interest rates are negative 10%. Using the above example, if you borrow $1B for a year at 0.25%, you're receiving a State subsidy of $100M. In a year, you have to repay $1.0025B, but inflation means the purchasing power it represents is approximately $900M. You borrow $1B, build a factory, and then repay with devalued money. This makes borrowing profitable and causes boom/bust cycles.
Why do you use useless jargon like "nominal" and "real" interest rates? They're meaningless, no one knows the true level of inflation, nor do they know the real rate of interest. Since this information is nonexistent, the Fisher effect should be ignored. There's the market rate of interest, which is seen, and then there's the natural rate of interest, which, like the real rate of interest, is unknown.
Nominal interest rates - the rate you can actually borrow at. The Fed Funds Rate is currently 0%-0.25%. There's nothing controversial there.
The inflation rate is measured in many ways.
It's very easy to measure inflation, if you know where to look.
Real interest rate = nominal interest rate - inflation rate.
fsk: he inflation rate is measured in many ways. There's the CPI, which is a bunch of lies and propaganda. There's M2, currently around 8%-9%. There's reconstructed M3, currently around 10%-20%. There's the price of gold, currently increasing at a rate of 20%-30% per year.
he inflation rate is measured in many ways.
Which one is correct? The monetarists had a very hard time measuring the money supply. As Greenspan said, "we don't know what money is anymore."
I consider the price of gold to be the most accurate measure of inflation.
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