A few terms explained

April 22, 2009 at 5:07 pm (Economics)

Vexed by all the technical finance terms right now in the news? At a loss when trying to understand how markets work? Can’t tell a stock from a bond to save your life? Try as we might, the world of finance is hard to understand. It’s not a natural system or a human system based on natural laws, so for that reason there are sometimes things that appear counterintuitive or simply don’t make sense. Read on if you wish to understand a little better the terms that are now thrown loosely on the news.

So, first things first, what is high finance?

Finance is divided into two main sections: corporate finance and high finance. Corporate finance focuses on a company’s internal handling of money. Where’s it getting it from, where to unload excess reserves of cash, how to make its handling more efficient; the works. People who work In this area are usually determining optimum inventory purchases and figuring out that the company can make an extra .01% return on investment if its sweatshop workers don’t get bathroom breaks. At all. It’s, all in all, a dull and tedious affair that has little more redeeming qualities than accounting.

High finance, on the other hand, is the sexy side of the profession we see glorified in movies like Wall Street. In essence, it’s the handling of financial assets such as stocks, bonds and derivatives. People in this area dedicate themselves to speculation and chasing after easy money in the markets. The most visible of these being the stock market.

What kinds of markets are there?

Besides the glamorous stock market, which, incidentally, is the smallest one of these, there are several other more important kinds. There’s the derivatives market, which has recently been getting a lot of bad rep because of their involvement in the current financial mess we’re in. The bond market, in which the debt of companies and countries is bought and sold like so many chickens at a bazaar, and the Forex market, where currencies are exchanged between banks, corporations and private investors.

Each of these varies in size, influence and impact on the real world. For example, the derivatives market, several times larger than the bond market, does not make governments tremble as the bond market does. More on that later. Involvement in these markets entails higher risk than playing in stocks, thus, you have to know what you´re doing if you decide to trade here.

How can Bond markets be so powerful? I thought they were boring and for old geezers

Simple. Bond markets are where the debt of countries and companies is traded. Bond markets are boring they same way plumbing is boring. Both are supremely important in their respective niches. A house with faulty plumbing is a real headache. So is an economy with a faulty bond market.

How? Well, imagine you’re asking for a loan to the bank. If you’re a responsible, forward thinking person, the bank won’t hesitate to hand you the money and you’ll probably get a better interest rate. But if you’ve spent the better part of your life smoking pot and other illegal shrubbery, then the bank will be loathe to loan to you. If they do, you’ll get a very high interest rate, to denote your high risk of default. Your supply of cash will be limited. The same things happen to corporations and countries, if they´re good, they can get a constant supply of cash from loans and continue to operate smoothly or finance large expansions. If they’re risky, they’ll be saddled with large interest rates and won´t have as much money available to finance their operations.

In this way, bond markets affect the workings of companies in the real economy. When the market freezes, like right now, even good companies cannot get loans at agreeable rates and are forced to perform unanticipated cutbacks.

What the hell is the Forex market? I’ve never heard of it!

In the Forex market banks, corporations and private investors exchange different types of national currency. Forex means “Foreign Exchange”, and that’s precisely what goes on. It´s purpose is not entirely speculative. Volkswagen may need to convert the reales they earned from selling in Brazil to Euros to pay their German employees. IBM may be looking to expand into Israel and must convert their initial dollars into shekels.

Forex markets are also powerful when it comes to politics. A run on a specific currency may cause that currency to crash and the impoverishment of its issuing nation. Such runs are common among third world countries, and can happen when their conditions deteriorate and investors scramble to pull their money out. Examples include the Mexican peso crash of 1994 and the Argentinean crisis of 2001.

Are the derivatives markets all bad? What do they really consist of?

The answer is still up for debate on that question. Derivatives are assets whose value depends on an underlying financial asset; at least, that’s the official definition. Derivatives essentially are bets that can be bough or sold.

Imagine we’re watching a Germany-Brazil soccer match. I make a one way bet with a friend over $100 that Germany will win. 40 minutes into the game the score is 4-1 with the Krauts at an advantage, but I suddenly have to go. I turn around and sell my bet to you at $60, after all the Germans are winning but there’s still about 50 minutes left to the game. If the Germans win, my friend pays you and you pocket $40 dollars profit. If Brazil turns around and wins, well, the bet was one-way, so you lost those 60 dollars you paid me for the right to own the bet. There’s a derivative for you. The underlying asset was the German team.

It’s the same concept in finance only that with more carefully planned out risks, rewards and probabilities. Derivatives are useful for companies when hedging against unfavorable exchange rate swings, for example, but they’re not limited to that. Employee stock options are derivatives too. They come in many shapes and sizes, but they’re also the ideal instrument for speculating, given they are, essentially, bets.

You mentioned hedging, what is that?

Hedging is simply the practice of protecting yourself against certain risks, in financial terms. For example, if you bought Euros because you thought they would rise, but were unwilling to take a loss, you could hedge by buying a derivative on Euros. This derivative would be an option that gives you the right, but not the obligation, to sell those Euros at a certain price.

On an unrelated note, what are Credit Default Swaps?

A Credit Default Swap (CDS) is a type of derivative that fundamentally means buying insurance on a loan. That is, if I loan you money, and want to make sure I´ll get my money back, I´ll go with AIG and buy a CDS on that loan. That means that if you fail to pay, AIG will give me my money, so I really don´t have to worry.

The problem right now with CDSs is that they were taken out on very funny loans, with the banks believing that the CDDs completely nullified the risk of giving deadbeats the possibility of buying up McMansions. Of course those loans were going to default and the CDSs were going to have to be paid. Think of a company that sold fire insurance to the Japanese for their paper houses in 1940, just before WW2 and the wave of American firebombing that swept Japan. The current crop of CDSs shows about just about the same business sense as our hypothetical Japanese insurer.

And then of course, there´s the bigger problem of naked Credit Default Swaps.

What’s a naked Credit Default Swap? Financial Porn?

I imagine that a naked CDS is as exiting to the financial guys as porn, but no, it doesn’t have sexual denotations. A naked CDS is loan protection without having to own the actual loan. Let’s go back to the houses and the fire. Normal people buy fire insurance for their own houses. Insurance compensates them in the tragic case their own house burns down and their family dies in a fiery hell. Screaming.

But enough with the sadism, what if an insurance company started selling fire insurance on other people’s houses? And for more than their market value? I could buy insurance that promises me $10 million if my neighbor’s house burns up. Of course I would stock up on gasoline cans and matches! Selling such schemes would be criminal in real life and yet, in the financial world they are known as Naked Credit Default Swaps.

What is a default, mind you?

It is when a borrower suddenly stops paying their debt. They don’t necessarily deny they owe anything; they simply can’t make the scheduled payment.

I’m interested in finding out more about this topic; can you recommend any good additional sources?

The Ascent of Money is a pretty good and intelligent book on the esoteric world of finance. PBS recently turned it into a full blown documentary. Barring that, there’s always www.investopedia.com, a finance encyclopedia.


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