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Non-Tech : Derivatives: Darth Vader's Revenge -- Ignore unavailable to you. Want to Upgrade?

To: Henry Volquardsen who wrote (259)	9/29/1998 5:25:00 PM
From: Larry Weiner	Respond to of 2794

Not to beat a dead horse here, but I think it's useful to distinguish between two types of derivatives. One is derivative securities, which are the inverse floaters, step-up bonds, IOs, POs, etc. These are bonds that are often issued under an agency label, like FNMA or FHLMC. They may be backed by mortgages, or they may be straight debt obligations of the agencies. In either case, they have little credit risk, but may have a ton of interest rate and liquidity risk, as Orange County and others found out in 1994. The other type of derivatives are derivative contracts. These are actual contracts like interest rate and currency swaps. These are contracts between 2 parties that each agree to make some sort of exchange of payments or cash flows, such as dollars for rubles at some predetermined rate. The big risk that these contracts have that derivative securities don't is counterparty risk, namely that the party on the other side of your contract (like a Russian bank, for example) decides not to honor their obligation to pay you. These are the types of "derivatives" that are in the news now.

To: Henry Volquardsen who wrote (259)	9/29/1998 7:10:00 PM
From: Pete Schueler	Read Replies (1) \| Respond to of 2794

Henry, I don't pretend to understand the intricacies of derivative instruments but I'd like to revisit Stitch's comment about underlying physical assets that are the bases for options. For instance, say there is a commodity like gold and assume there is "X" tons total physical supply. Then assume that many "investors" believe that its price will go down and just as many others think it will go up. Now they buy options, puts and calls that amount to gold quantities that total 2X tons of gold. In this case could a sudden price move combined with physical delivery drive demand beyond supply and create a massive default? Also, if this process begins to unfold won't the people on the wrong side continue to write more contracts to protect their underlying positions until they have created a real monster? Thanks for your excellent comments, Pete