Let's Make Up the Biggest Number We Possibly Can

It must be fun to write articles about the derivatives market, because you can say things like "the derivatives market is now $75 octillion billion trillion dollars, or five million times the total wealth conceivable by Han Solo in Star Wars."

Okay, maybe not that much, but still, you can pick a really big number and then say some dire things.

I have blogged before that big numbers in financial reporting are often somewhat meaningless, and I suspect that the numbers being thrown around for the size of the derivatives market are similarly silly.  To illustrate, let's demonstrate how you and I can increase the size of the derivatives market by about $28 trillion.  It won't cost us much.

• We enter into a futures contract written against the US GDP.  Basically for every $1 of growth in the GDP from 2008 -> 2009 you will pay me $1 - for every loss, I pay you $1.
• We assign some kind of "value" to this contract based on the expected change in GDP (probably you will have to pay me to enter this contract - GDP is shrinking right now so I'm almost certainly going to pay you when the contract is up).

So we've exchanged some smaller amount of money based on the probably net change in GDP, and we've created a new derivatives contract with a notional value of $14,000,000,000,000.

Now we do the same thing again, but we reverse the direction.  (This is admittedly a very, very silly thing to do, but it is meant to illustrate a point.)

Now there are $28 trillion in new derivatives, and we are each in a position to make or lose exactly $0.  In financial terms, we are both "hedged" because our two derivatives contracts exactly cancel each other out.

The issue with the derivatives market is not how large it is notionally, but how well hedged all of the contract holders are.  It is possible that the major investment banks are not as well hedged as they thought (see what happened to LTCM), and in rarer cases they may not be hedged at all.  (See: AIG)

But the notional quantity of derivatives tells us nothing about their quality, which is what will really matter.