Eli5: It’s said that the derivatives market is worth over $1,000,000,000,000,000. Where did all of this money come from?

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Eli5: It’s said that the derivatives market is worth over $1,000,000,000,000,000. Where did all of this money come from?

In: 5

Speculators.

To invest in a company, you have to do a lot of fact-finding about that specific company.

If you just have a hunch, that’s hard to invest directly in. To appeal to this sort of speculator, derivatives generalize a market niche and offer a pre-made package of assets.

Nowhere because that money doesn’t really exist. That value comes from taking all contracts currently open and adding up the value if they were all executed. This is a terrible way to determine value. Its like making you own company with 1 trillion shares and convicting your friend to buy 1 shares for a dollar. Do you really think that company is now worth $1T? In reality 85% of contract expire worthless and the majority that dont are part of some hedging strategy so there are other off sets.

That’s money from the future.

People basically trying to predict the future and betting on happening of some of the events. When the times are good, betting is easier, because everything is predictable. In unpredictable times it is impossible to predict the future and derivatives market crashes

It isn’t money, it is possible value.

Let’s say you have a banana stand, and you say you will give me the option to buy it from you in a month for $1000, if I pay you a dollar today. Let’s pretend I am intrigued by the idea that you might do something amazing with that banana stand so I give you a dollar.

We now have a derivative worth around a (currently functional) $1000 asset value, but only a dollar is involved.

Now imagine I tell someone else they can buy that banana stand from me in two months for $2000 if they pay me $1 today and they say ok.

We now have $3000 of assets in derivatives with only $2 actually in the mix.

We could get to big numbers pretty quickly, so keep me posted on your banana efforts.

But most likely none of us will exercise those options. Enjoy your dollar.

The best way to look at it is with a “simple” example.

Let’s say you own $1 million in stock. You’re worried that the stock might go down, so you want to buy insurance against that.

Now, let’s say someone else is happy to sell you that insurance. They say, “I will buy $1 million in stock from you at the current price for the next two years. If you agree, you pay me an insurance premium of $25,000.”. You decide it’s worth it and you write this contract, known as a put contract, with this person.

You’ve just added $1 million in value to the derivative market, or the nominal amount of stock covered by insurance contracts.

But wait, there’s more — person B gets tired of holding your contract and decides they want to sell it, but you don’t want to sell. So they find a third person, and they agree to write a contract to person B. The contract is quite similar to yours and Person’s B’s, where they get the right to sell at the current market price $1 million of stock.

In a practical sense, person C is now your insurer.

In reality, another $1 million has been added to the derivative market. It’s the same stock, but it’s two separate contracts. These contracts in fact balance liability for one party and shift it to another, but it still seems like a large number of derivatives are written when you look at the nominal face value of all insurance contracts.

In the strictest sense, this quadrillion figure is ultimately meaningless as a result. You could take on $1 billion liability and instantly offset it with the exact opposite contract and be in no riskier a situation while still adding to that figure.

However, like any insurance, and any financial products, you CAN get yourself in a lot of trouble speculating or poorly offsetting your risk with them, so it’s vastly more important to understand your risk profile than any nominal value of the worldwide derivative market to make sense of these things.