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Understanding Derivatives


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Easily understood explanation of derivative markets

We read about them all the time but most of us haven't got a clue what they are. But a kind gentleman came to our rescue and emailed this article to us so that we can all understand ...

Janice is the proprietor of a bar in Hackney. She realises 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 a brilliant new marketing plan that allows her customers to drink now, but pay later.

Janice keeps track of the drinks consumed on a ledger (thereby granting each customer a loan). Word soon gets around about Janice's "drink now, pay later" marketing strategy and, as a result, increasing numbers of customers flood into Janice's bar. Soon she has the largest sales volume for any bar in Hackney - if not the whole of London.

By offering her customers freedom from immediate payment demands, Janice gets no resistance when, at regular intervals, she substantially increases her prices for wine and beer, the most consumed beverages. Consequently, Janice's gross sales volume increases massively.

A young and dynamic manager at her local bank recognises that these customer debts constitute valuable future assets and increases Janice'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 in The City, expert traders figure a way to make huge commissions, and 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 triple-A secured bonds are really the debts of unemployed alcoholics. Nevertheless, the bond prices climb continuously, 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 Janice's bar. So he informs Janice. Janice then demands payment from her alcoholic patrons. But, being unemployed alcoholics, they have no money and cannot settle their drinking debts.

Since Janice cannot fulfil her loan obligations she is forced into bankruptcy. The bar closes and all eleven employees lose their jobs. Overnight, the price of DRINKBONDS, ALKIBONDS and PUKEBONDS drops 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 Janice's bar had granted her generous payment extensions and had even 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.

Then Janice's wine supplier succumbs to bankruptcy, closing the doors on a family business that had traded for three generations; the brewery that supplied all her beer has to sell out to a competitor who immediately closes the local plant and lays off 150 workers. It's a tough time and the repercussions keep accumulating, hitting more and more people.

Fortunately, though, the bank, the brokerage houses and their respective executives are all saved. They are bailed out by a multi-billion pound 'no-strings attached' cash infusion from their cronies in Government. This almost bankrupts the country but the funds required for this bailout are easily obtained by new taxes levied on employed, middle-class, non-drinkers - the vast majority of whom have never been to Hackney, let alone drunk in Janice's bar.

Any questions?


"Many men stumble across the truth ... but most manage to pick themselves up and continue as if nothing had happened."

Winston S Churchill


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