A question for the derivatives gurus

bronco2078

Can someone more familiar with derivatives explain how they generate profit?

My basic assumption is that the derivative has a face value which it is sold for is that correct? Does the holder receive profits from holding it like a periodic stock dividend or from selling it after it increases in value ?

Does the creator of the derivative make a profit only from the creation and sale and they are done with it? or do they get servicing fees as it continues to exist?


The reason for my question is this , with the 100's of trillions of notional value in derivatives sloshing around the globe where is the tax revenue ?

I understand corporate taxes aren't the same as personal taxes but shouldn't 100 trillion in derivatives generate at least 1% of that in taxes in any given year? 1 trillion in taxes to some government? or 4 trillion or 500 billion ?

Is there any evidence that the entities trading these things pay any taxes on the trades at all?

jmski52

There are lots of different types of derivatives, and I can only give you examples of the easy ones.

An options contract is a derivative. A futures contract is a derivative. An ETF is a derivative. A derivative is simply an amalgam of various underlying securities or assets. Basically, as a performance contract, they generate a profit when they are sold off for a higher price than what they originally cost, less expenses.

Credit default swaps and interest rate swaps are beyond the scope of my expertise, but I assume that they are simply performance contracts as well.

Regarding the tax issue, unless the thing is throwing off a stream of income, i.e., interest or earnings, I don't think that it would accrue any tax liability until it gets sold.

I'm guessing that most of the derivatives that are in the black have been tax-sheltered or used to offset some costs in the large entities that own them. You can be sure that the tax attorneys have been busy making sure that the net effect is positive before anything is cashed in.

Since the banks who own the losing positions are allowed to carry them on their books at whatever value they like (thanks, FASB) there is no downside to being on the losing side, as long as you have political friends. The downside is being a taxpayer without political friends.

derryb

Derivatives are financial instruments whose value is linked to something else. They're basically fancy instruments that have evolved over the last ten years that enable investors and institutions to bet on virtually anything, from interest rates or exchange rates to commodities.

Normally it is backed by nothing more than the other party's promise to pay. There is no underlying "collateral" such as a claim to the company (as with stocks) or a claim to the bullion (as with some ETFs and other funds that are actually backed by physical metal).

Tax revenue liability is generated when a position is closed at a net profit. I do know that when I close an ETF derivative position at a net profit the IRS is informed via 1099 at the end of the year by my broker.

A credit default swap is a bet on whether some entity - a company, a government agency - is going to default on its credit and go bankrupt. An example: Someone who loaned money to Lehman Brothers (by buying their bonds) might bet on Lehman going belly-up. Why? To protect their bonds. Lehman fails; they lose on the bonds, but cash in on the bet. It's a form of insurance. The price they pay for the "credit default swap" is, in essence, the insurance premium.

bronco2078

The mortgage backed securities would normally generate a ton of taxes as they pay out in a monthly income stream .

By purchasing those on the open market the Fed gains control of those income streams , shaves 6% or whatever off for its shareholders and deposits the rest in the treasury. . Since the shareholders of the Fed are its member banks I wonder how much extra money they are making due to the massive expansion of the Fed's balance sheet . They still only get a 6% dividend but the actual income could be an order of magnitude higher with all the stuff they have been buying.

I always assumed the securities they were buying were the toxic ones that weren't producing any income to speak of but maybe thats wrong.

RedTiger

In real simple basic English terms, all derivatives are bets. The price of the derivative, is derived from something else, it might be a stock or a commodities futures contract. The derivative itself is a wager, nothing more, nothing less. The profit comes from the vig, the vigorish, from each bet. Each time a bet is made, the house, the bookie, the option exchange, takes their bit and that is where the profit is.

Listed derivatives are heavily regulated. There are hourly checks on margin balances. The danger is in the unlisted market, where many of the big boys play. Most do not allocate enough margin to secure their bets. Once in a while someone like the London Whale (google that if you are not familiar with the story), bets too big and loses their shirt. If a lot of folks do similar, there can be stress on the entire financial system because of the leverage involved. Even in the PCGS trading contest, they let someone use 100x leverage in the contest, even though no small fish can make that kind of trade in real life on listed options. 100x leverage can be achieved by small fish traders, but that is usually with offsetting bets so the real dollar risk is tiny, or 100-to-1 long shots where the chance of winning is 1%. The headline is 100x leverage and the know-nothings get all excited and bothered.

Small timers often like the leverage and the lottery ticket aspect of some derivatives, so that generates trading volume. Again, the profit comes from the trading volume, from getting people to make lots of bets. The house always has the advantage, always collects their vig from the betting public.

cohodk

Derivatives are like insurance policies. A small fee can buy lots of protection. For example you can buy $1 million worth of life insurance for $1000 per year.

For your tax question I refer to jmski52's answer. A stock option is a derivative. For example I can buy an option that controls 1000 shares of Apple stock representing over $400,000 worth of stock for as little as $4000, or less than 1%. So there is little tax revenue. The derivatives you read about carry even higher margins and as such even smaller income. So to answer, no, there is no windfall profit in these financial "products".