RIP Philo

An Example Of How Banks Steal Via Derivatives

In this thread, I mentioned how negative real interest rates feed derivatives markets.  I'm posting my example as a separate thread.

Can you walk us through that math?
I buy a call, bank sells it. For example, if that works as a start.

>Complex financial instruments do provide some value in some places. For example, they're a relatively cheap form of insurance in some instances; say, an airline wants to lock in the price of jet fuel. But they've been very poorly regulated and net net, their cost to society exceeds their benefits.

Actually, that was the example I had in mind, an airline making an oil price hedge.  I'm more familiar with the rules for equity markets, but futures markets are similar.

Suppose the airline wants to hedge the price of oil.  Suppose they decide to buy a $1B underlying 1 year call spread, locking in a price range of $80-$120 per barrel.  (i.e., they pay at most $120 and at least $80 per barrel, and if the price is between $80 and $120, that's what they pay).

The airline enters a derivatives contract with a bank.

The quant at the bank is using the Black-Scholes pricing model.  The bank borrows money and buys oil futures, hedging the trade with the airline.  The bank can borrow money at the Fed Funds Rate (or 1 year Treasury Rate), say 0.25%.  The implied interest rate in the option contract is 0.25%.

However, the bank adds on fees and spread when they sell the call spread to the airline.  What the airline actually buys has an implied interest rate of (say) 3%.

This is a great deal for the airline.  If the airline issued bonds to finance their oil speculation, they would pay 6% or more.  They instead got to borrow at 3%, via the derivatives transaction.

This is a great deal for the bank.  They are borrowing at 0.25% and lending at 3%.  They are taking on some risk that they misestimated the volatility or don't hedge correctly, but it's a positive expectation bet for the bank.

Also, true inflation is 10%-20% or more.  On average, oil prices will go up at least 10%.  It's a great deal for the airline to hedge at an implied interest rate of 3%.

Both parties book an immediate profit on the transaction.  The bank is borrowing at 0.25% and lending at 3%, a sure profit for them.  The airline is borrowing at 3% instead of their normal cost of capital of 6%, a sure gain for them, especially when you consider that oil prices will (on average) go up 10% or more per year.

Where are these profits coming from?  Is it because the bank traders and airline hedging desk are such geniuses?  That's what they think, but that's not what's actually happening.

When the bank borrows money to finance the transaction, they are borrowing BRAND NEW MONEY from the Federal Reserve, either directly or indirectly via another bank.  This new money causes inflation.  The inflation caused by this new money is actually greater than the profits earned by the banker and airline.

So, the airline and bank make a profit.  But the rest of society experiences greater inflation and greater prices.  Via this mechanism, wealth is transferred from the average working stiff to the big banks and the large corporations that get to borrow cheaply.  Also, this mechanism usually destroys wealth; the inflation caused is greater than the profits earned.

You can say that the banker is a swell guy for making the airline more efficient.  However, it's a corrupt financial system that makes this transaction profitable.  It's impossible to have real reform, because the big banks literally have an unlimited lobbying budget.  They get this huge firehose of free money via negative real interest rates, and spend a lot of that free money lobbying to keep the scam running.

Some people say that banks do good things when they finance businesses.  However, they rigged the monetary system so that borrowing from the bank is the best option.  With negative real interest rates, borrowing is always going to be more attractive than reinvested earnings.

It's a very clever scam.  The details are not taught in school, on purpose, to keep the slaves clueless about what's going on.  It isn't taught in "mainstream economics", because the #1 employer of economists is the Federal Reserver.  It isn't an accident.  The people who set up the financial system knew exactly what they were doing.  They set up all kinds of smoke and mirrors fake reforms.  The real problem is negative interest rates and a corrupt monetary system.
Permalink FSK 
December 23rd, 2013 11:35pm
Why do you need a derivative in the middle of this?

Bank borrows at 0.25% from the fed or its depositors.

Loans to airline at 3%.

That's what banks do.
Permalink Walter 
December 23rd, 2013 11:47pm
Higher commissions.
Permalink Colm 
December 23rd, 2013 11:55pm
Normally, they lend at 6%, and the bank is an unsecured creditor.

In the case of selling a call spread, the bank is paid the premium cash up front.  There's no default risk, so the implied interest rate is lower.
Permalink FSK 
December 23rd, 2013 11:56pm
interesting. thanks for that.
Permalink eek 
December 24th, 2013 1:35am
tl&dr: Business buy low and sell high.

A SCAM!!!!
Permalink Quant 
December 24th, 2013 5:22am
"Also, true inflation is 10%-20% or more."

This is your mistake.
Permalink Shylock 
December 24th, 2013 7:08am

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