Thursday, April 4, 2013
Trixie Explains Derivatives
Last night, I was at Rocks in Albany, watching about a dozen drag queens dance and lip sync on a stage, while the crowd went wild.
There was one drag queen, Pandora Boxx from Ru Paul's Drag Race (which is a show I don't watch, so I have no idea...)
There was lots of dance music, and the 'gurls' were doing high kicks into the audience.....and a friend turned to me and said, "I can't really see Trixie doing that..."
"Yeah," I said to him, "that's not happening."
I understand that that is what people want from drag queens - high energy, dancing, high kicks, fake singing, tons of makeup - and I'm very happy that there are plenty of drag queens who do that, and provide that level of entertainment.
I told my friend, "I would feel much more comfortable explaining the concept of financial derivatives in drag than lip-syncing to Lady Gaga."
This is a blog post I've had in my head for a while, a couple of years now. Since that whole Greece thing happened.
America has this concept that derivatives are bad, and that they caused the last market downturn.
Well, not really.
The economy went down, because, well, it kinda needed to....and a more stringent financial future lies ahead.
Derivatives are not necessarily the CAUSE of bad and evil, they are just another way to trade...how people TRADE, well, that's the issue....
A derivative means that you are not trading the actual THING, or asset - you are trading something else, that's RELATED TO or DERIVED FROM that asset.
For instance - and I'm going to use real estate as an example....why? Because gay people understand real estate....
Let's say you have two neighbors on Union Street, in two very nice houses.....similar.....
And, they have the same mortgage amounts on their houses......$100,000 each. They both LOVE their house, and they LOVE living in Hudson - as we all do.
BUT - one has a floating rate of interest, which changes every six months, and right now, it's at 3.5%, and the other has a fixed rate of interest - at 5.5%.
They both have 15 years left on their mortgage.
The question is, 'Who will pay more in interest in the next 15 years?'
Oh, it's a trick question.
You don't know.
The floating rate adjusts every six months, so who knows where it's going to be years from now.
Now, this is where the FUN starts!!!
The family in House A with with the floating rate of interest - they are optimists! They believe in the US economy!! The US will get out of its current malaise, the economy will boom and interest rates will naturally go up. House A has the floating rate, which they know will go up. They wish they had the fixed rate.
The family in House B, with the fixed rate, they're pessimists....they believe that the US is the next Japan. We are destined for a stagnant economy. The Fed (the US Federal Reserve Bank), in order to help boost lending and borrowing, and potential growth, will lower the Fed Funds Rate, keeping interest rates low....even lower than now. House B has the fixed rate, which they know will go down. They wish they had a better deal and got the floating rate.
They love their individual houses, they are not going to move.....but they both hate their mortgage interest rates.
And they HATE those stupid fees and everything that's involved in refinancing....so, that's not an option. ("Options" I'll save for a later time....I can't give out all the fun at once.)
Trixie steps in with an idea.
Since you both have the same principal left on your mortgages, and you each want the other's mortgage interest rate, why don't you just exchange mortgage payments, not houses! This way, you don't have to move....
That's what they do.
They both agree that each will pay the other's mortgage payments for the next 15 years. They are not moving, or even changing mortgages.
They will still own and live in their individual houses.
The house that has the fixed rate of interest pays the floating rate over 15 years, and the house that has the floating rate pays the fixed.
Signed, sealed. Done.
This is a derivative deal.
The underlying assets, or houses, are not being exchanged, nor the mortgages themselves - just the mortgage payments.
They are swapping mortgage interest rates. This is known as an 'Interest Rate Swap' - the most common derivative.
With derivatives, there's no stock or house or asset or anything that's being exchanged....just the interest rates....the 'trade' itself is the agreement to pay the other's interest. The 'trade' is 'derived' from some other asset - in this case the houses.
Maybe next time, I'll discuss wheat futures with half-naked cowboys as examples.
Or, I'm sure by now, many of you would rather I just lip-sync'd.