Jake Towne - Talk To CC-BASD On Financial Derivatives (18 Aug 09)

TowneForCongress.
com
Talk on Financial Derivatives to
CC-BASD 18 Aug 2009
 Introduction
 Why care about derivatives?
 What ARE derivatives? (and swaps!)
 Dangers of derivatives
 What if I owned derivatives?
 Q&A
TowneForCongress.com
Why care about derivatives?
“Derivatives
Photo courtesy Mark Hirschey

are Weapons
of Mass
Destruction!”
- Warren Buffet, 2003
Q: How much is a Trillion?
A: $1,000,000,000,000
A Trillion is a “million millions”
If I paid you $1,000,000 a DAY, to reach a Trillion dollars
you would have needed to start working in 731 B.C.!!
Courtesy Chris Martenson

A Trillion-dollar stack of $1,000 bills would stretch from
Bethlehem to Philadelphia (67.9 miles)
All values in Trillions of USD
10
9
8
7
6
5
4
3
2
1
0
U.S. M2 Money Supply (Aug '09)
 Source: The Federal Reserve at http://research.stlouisfed.org/fred2/series/M2
16
14
12
10
0
U.S. M2 Money Supply (Aug '09) U.S. GDP ('08)
 Source: Bureau of Economic Analysis at

http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm
60
50
40
30
20
10
0
U.S. GDP ('08)
U.S. M2 Money Supply (Aug '09) World GDP ('08)
 Source: U.S. Global

www.usfunds.com/webcast/CreditBubbles/Credit_Bubbles_Replay.pdf
60
50
40
30
20
10
0
U.S. GDP ('08) EXD Derivatives (Mar '09)
U.S. M2 Money Supply (Aug '09) World GDP ('08)
 Source: Bank for International Settlements (BIS) at

http://www.bis.org/publ/qtrpdf/r_qa0906.pdf#page=108
80
70
60
50
40
30
20
10
0
U.S. GDP ('08) EXD Derivatives (Mar '09)
U.S. M2 Money Supply (Aug '09) World GDP ('08) World Real Estate ('08)

120
100
80
60
40
20
0
U.S. GDP ('08) EXD Derivatives (Mar '09) World Equity and Bond Markets ('08)
U.S. M2 Money Supply (Aug '09) World GDP ('08) World Real Estate ('08)

All values in Trillions of USD, best figures as of Aug 2009
600 The crux of the OTC

derivatives issue is its
enormous size relative
500
to rest of the financial
system.
400
300
200
100
0
U.S. GDP EXD Derivatives World Equity and Bond Markets
U.S. M2 Money Supply World GDP World Real Estate OTC Derivatives
 Source: Bank for International Settlements latest, December 2008

http://www.bis.org/statistics/otcder/dt1920a.pdf
What ARE Derivatives?
Derivatives began in the

1700s in imperial Japan's
Dojima Rice Exchange.
The Tale of Joe the

Samurai and Bob the Trader
Spot Price & Future Price
Modern financial derivatives all started with commodities, namely rice and grain. The earliest recorded
financial derivative market I know of came in the early 1700s in imperial Japan at the Dojima Rice
Exchange. Although the realm did use coins, they also used rice as another major form of indirect
exchange. (Part 3 explained why using rice was a horrible idea.) The samurai stole (or to be more
polite, taxed) rice from their serfs, but due to a set of bad harvests and market manipulations by
traders, they found their purchasing power to be very adversely effected. A funny way to think of it is
that new armor & swords, and lovely geishas were too expensive in terms of rice. Our poor samurai
were left scratching their helmets on what to do.
The samurai decided to sell their harvests forward to stabilize their income. For instance, Joe the
Samurai convinces Bob the Trader to give him a set amount of coinage (say 15 coins, or the futures
price) in exchange for his rice crop (say 1 bushel) that will be delivered on a settlement day (say 3
months later). When this "futures contract" settlement date arrives, Joe gets the 15 coins, Bob gets
the bushel of rice and sells it, hopefully for the price he was expecting to receive, say 18 coins. Joe
gets the steady income he desired. Bob makes a tidy profit of 3 coins in return for risking that the
price of rice would drop below the spot price on the date he sells the bushel. In other words, Joe the
Samurai trades his price risk (the rice's price volatility) for Bob the Trader's basis risk (the difference
between the futures price and the spot price). Spot price is the market price for immediate delivery on
the day Joe and Bob made the contract).
This process of transferring risk from those without capital to those that do for the possible economic
gain of each can enable overall economic growth. However, let's say there is a glut of rice, depressing
the price on the settlement date. Joe the Samurai is still happy; he still gets his expected income.
However, Bob the Trader will take a loss. Bob the Trader also has the possibility that rice will be
scarcer than expected, leading to higher profits for him. Likewise, if Joe does not produce the rice, he
has no income, and perhaps also needs to pay Bob the Trader his expected basis risk to compensate
for tying up his capital.
What ARE Derivatives?
Simplified, the term "derivative" refers to a

"derived" wager, or bet, on the price of something.
Derivatives are financial contracts whose values
are derived from the value of something else, which
is termed the "underlying" asset. The main use of
derivatives is to transfer risk for one party.
There are many types of derivatives – futures,
options, swaps, etc – covering different types of
“underlying” “assets” - commodities, interest rates,
FOREX, equities, credit defaults.
What ARE Swaps?
An agreement by two parties to exchange (swap!) a
series of cash flows in the future.
Dangers of OTC “Dark” Derivatives
“Bring Light to Dark Derivatives!” - Jake Towne, 2008
Over-the-counter derivatives are very loosely regulated

and directly traded between two parties.
Quite likely, many OTC derivative contracts are

insolvent since corporations cannot cover in the case of
one party defaulting.
Requiring traders to use an exchange or publish proof

of solvency should be required of corporations.
The Pregnant Economy's Credit Baby
Photo courtesy Petercantfail

Notional Amount OTC "Dark" Derivatives 1998-2008
(Data courtesy bis.org - Jake Towne)
800
700
600
in Trillions of USD
500
400
300
200
100
0
Dec.98
Dec.99
Dec.03
Dec.04
Dec.05
Dec.07
Dec.08
Jun.99
Jun.00
Dec.00
Dec.01
Dec.02
Jun.04
Jun.05
Dec.06
Jun.07
Jun.08
Jun.98
Jun.01
Jun.02
Jun.03
Jun.06
Massive Credit/Debt Expansion from 1998 – June 2008. Start of credit contraction???
What if I owned derivatives?
1) Know WHY you are buying.
2) Know WHAT you are buying.
– Read and understand the text of all agreements
– Identify all possible transaction fees
3) Know your counterparty risk
– Identify whether contracts are EXD or OTC
3) Never “bet the farm.”
4) The derivatives market is largely frozen. This means that
contracts may not be able to be valued or sold.
– Do NOT trust the value given to a contract by a third
party – the monetary value of the contract is just
what it can be sold for, nothing more.
Some Available Speaking Topics
“Truth is Treason in the Empire of Lies.” - Dr. Ronald Paul
"I bring reason to your ears, and, in language as plain as A, B, C, hold up truth to your
eyes... I fear not. I see no real cause for fear. I know our situation well, and can see the
way out of it." - Thomas Paine, The American Crisis, 1776
1) What is Money? - A discussion on money and credit
2) A Parasite and A Relic - How the Federal Reserve Works
3) Honest Money - Gold and Silver
4) Bring Light to Dark Derivatives - Intro to Financial Derivatives and their Danger
5) Why the Government's Stimulus Plans Won't Work - A critique of central planning
6) The Only Time Jesus Got Really Upset - The Moneychangers and Modern Usury
7) Why You Can't Retire! - The Current Keynesian Monetary System
8) Why the War on Terror Must End – Facts and discussion on the path forward
9) The Financial Crisis - An Austrian View at the Causes and How to End It
10) The Federal Income Tax - A Solution to Immoral and Unnecessary Taxation
11) A Real "Stimulus Plan" for Local Communities - Local Currencies and Coupons
12) My Personal Experiences of Living in China - Church-going, Freedom, One
Child Policy, Thoughts on Economy and Relations with the USA, Taiwan, and Japan
✔ Of course, I can speak on other topics depending on group preferences.

Graphics Acknowledgements
Unless listed below, all photos are either mine or public domain.

The “Towne 2010 – As Good As Gold” logo was created by Derek
Wyatt

The Warren Buffett photo courtesy Mark Hirschey LINK LICENSE

Stack of $1000 bills courtesy ChrisMartenson.com
Source List
Place the cursor over the title to access the link. Here is a LINK to a
summary of my writings and my semi-bibliography.
Federal Reserve Bank of Boston. Pages 3-5, 10 on different types of derivatives
and swaps. "Tools of the Trade: A Basic Guide to Financial Derivatives."
Martenson, Chris. “How Much Is A Trillion?” VIDEO.
Towne, Jake. 2008. “The Money Matrix – What the Heck Are Derivatives?”
Towne, Jake. 2009. “The Money Matrix – Bring Light to Dark Derivatives”
Document Copyright
Copyright © Jake Towne, 2009. Any portion of this presentation that could be
copyrighted is owned by myself and I hereby released it to the public domain. I
grant full permission to use any of the ideas or material within. You may republish
this work. Attribution to myself is appreciated but not required.
Closing Remarks
* I am running as a citizen, not with either major party - What I offer to the citizens
of the 15th district, and many do belong to the two main parties, is a truly
independent voice and ear.
* I am not a career politician. If elected, I would plan to run again in 2012, but
following this I would most likely not run again. My aim is to serve as a temporary
statesman and representative and then leave government. I am more mindful than
most of the sad truth behind "Power corrupts and absolute power corrupts
absolutely." As collateral for this assurance, if elected, I will not enlist in the
Congressional pension plan, which guarantees members up to 80% of their salary in
annual pension. I believe this is fiscally irresponsible and too lucrative. The current
salary for a seat in the U.S. Congress is $174,000. I view this as too lucrative given
the current purchasing power of the dollar, so obviously I would act to reduce
Congress's salary and mine - how can the people believe Congress will tighten the
purse-strings on government if Congress fails to start with itself? I support tying the
salaries of our Congress in some manner to household median incomes.

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TowneForCongress.

 What ARE derivatives? (and swaps!)

 What if I owned derivatives?

Photo courtesy Mark Hirschey

Courtesy Chris Martenson

 Source: The Federal Reserve at http://research.stlouisfed.org/fred2/series/M2

 Source: Bureau of Economic Analysis at

 Source: U.S. Global

 Source: Bank for International Settlements (BIS) at

 Source: U.S. Global

 Source: U.S. Global

600 The crux of the OTC

 Source: Bank for International Settlements latest, December 2008

Derivatives began in the

The Tale of Joe the

Spot Price & Future Price

Simplified, the term "derivative" refers to a

Over-the-counter derivatives are very loosely regulated

Quite likely, many OTC derivative contracts are

Requiring traders to use an exchange or publish proof

Photo courtesy Petercantfail

✔ Of course, I can speak on other topics depending on group preferences.

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