An Easily Understandable Explanation of Derivative Markets
Economics 101
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 their cronies
in Government. The funds required for this bailout are
obtained by new taxes levied on employed, middle-class,
non-drinkers who have never been in Heidi’s bar.
Now, I understand