Financial Reform Bill

**Jet Gorgon** · 27-04-2010, 01:11 AM

I wonder what surprises will be in this bill. I just read that futures contracts may be included. Since when are futures "exotic" investments? They are necessary tools for farmers, airlines, trucking & train cos, among others to plan their future costs.
A $50 bil kitty will be set up for bail-outs -- that's not even close to what could be needed, plus, it will serve as a slush fund.
And a consumer protection clause? Crikes, the average Joe Blow does not trade in the more sophisticated of these markets (like CDOs) that caused the last crisis.
Now, Democrat Darling Buffett is demanding that current derivative contracts not be affected (guess that's coz Berkshire Hathaway has a $63 Bil deriv portfolio).

This goes for a vote to debate a bill today. Another ram thru job? It smells like another rahm dead fish.

But, a very populist move for the libbies, who sniff the public's anger over Wall Street profits. Hmmm, why doesn't anyone get angry at movie stars and athletes who rake in the millions?

UPDATE 1-Decision near for financial reform in U.S. Senate | Reuters
Moneynews - Buffett's Berkshire Seeks Special Financial Reform Treatment: Report

**sabang** · 27-04-2010, 11:44 AM

Originally Posted by Jet Gorgon

I just read that futures contracts may be included.

I certainly hope so. The proposal (as I understand it) is to have OTC options and futures contracts traded on public exchanges, as are shares and exchange traded options- and for that matter, exchange traded futures, which are now dwarfed by the 'Over the counter' markets. The benefits of this in terms of market efficiency, and market transparency/ information are tangible. And ultimately, in terms of price to the customer- who benefits from a more open, efficient marketplace.

It would also, likely, reduce the profits the Investment banks make by skimming and arbitraging these opaque markets- hence their opposition to it. But it is definitely in the public interest.

Plus, of course, you now have some sort of information available of the amount of money being (in most cases) gambled on these highly volatile markets. The importance of this cannot be overestimated, when you look at the recent financial crisis and the contribution of opaque, speculative derivatives contracts to it. When these imploded, it brought down the Investment banks and AIG with them. Exactly the thing Warren Buffet, amongst others, was warning about for many years.

**Camel Toe** · 27-04-2010, 12:04 PM

I have stock in WellPoint. Do you think this bill will force WP to pay their insured lower class sick people for life-saving medical treatment and render my annuities devalued?

**Butterfly** · 27-04-2010, 12:12 PM

Futures are always traded on the exchange, they are the equivalent of Forwards OTC on an exchange

maybe you meant Forwards ?

**sabang** · 27-04-2010, 12:24 PM

Forwards are OTC Futures contracts. I suppose if we include the more exotic synthetic instruments, they might contain an options element too.

Is it current parlance to call OTC contracts 'Forwards' then? Were't really in my day- I mean a Forward contract as such can be written as an option or future, can be long sided or short side, straddled or spread. Kind of a generic term.

**Butterfly** · 27-04-2010, 01:28 PM

Originally Posted by sabang

Forwards are OTC Futures contracts.

actually it's referred the other way around, Futures are the equivalent of Forwards (OTC) on an Exchange

Originally Posted by sabang

Is it current parlance to call OTC contracts 'Forwards' then?

Yes, Forwards are private contracts traded OTC (dealers market), usually customized and carry a counter party default risk. The standardized version traded on an Exchange is the Future contracts, and they don't have default counter-party risk, the exchanges covers it (daily marked to market).

Originally Posted by sabang

Were't really in my day- I mean a Forward contract as such can be written as an option or future

completely different beast, you probably forgot what they are (can't blame you, they are quite complex instruments to remember). Options are contingent contracts, while Forwards and Futures are commitment. Options on Forwards exist but they are private and Options on Futures also exists but they haven't been very successful except for a particular asset class but can't remember which. Forward pricing though will often track those of Futures as they might use the same benchmark or "underlying rate", so they are often "merged" in discussions, but they are also different beats because of the counter-party risk and the customization issue.

Originally Posted by sabang

can be long sided or short side, straddled or spread. Kind of a generic term.

A series of forwards are called Swaps. There can be any kind of options strategies involving shorting and going long. You can "stop" a forward by entering into an opposing contract at expiration.

My head hurts,

**sabang** · 27-04-2010, 01:49 PM

The term 'Forward' was only used by us to refer to non- contingent (futures type) contracts too actually- just pointing out that, generically, an option is still a contract on a 'future' delivery. And of course, if you sell as oppose to buy Call options unhedged, you also face a potential unlimited liability.

But enough of this merry banter- what do you think about the proposal itself, to incorporate OTC contracts under Exchange trading BF?

**Butterfly** · 27-04-2010, 01:56 PM

Futures are non-contingent, they are commitment. Only options are contingent. The future delivery of options is only a bet, but in actual Futures contract, you can't escape the delivery or the settlement. Remember that no money is exchanged in Forwards at the beginning of the contract (except for foreign currency Forward Rate Agreement if I am not mistaken), only at expiration there is a settlement on the Notional.

In options, there is no settlement, only a premium to be paid for the one taking the risk (the short), and you obviously can default on the delivery (the long). If the option is out of the money, you are not going to deliver.

**Butterfly** · 27-04-2010, 01:59 PM

Originally Posted by sabang

to incorporate OTC contracts under Exchange trading BF?

I haven't read the details of the proposal, only heard glimpse of it. It seems a bit ambition and infeasible. I think they want the banks to spin off their derivatives division, probably the dealers or proprietary trading.

OTC is "unregulated" for a very good reason, it creates flexibility and it's needed to cover certain risks. Without those, companies will be "uncovered" and who knows what it would mean in the long run.

At the end, the government will have to rely on banks to "report" their OTC derivatives, so who knows how reliable this is really.

**Butterfly** · 27-04-2010, 02:06 PM

sab, do you have a link of the entire bill ? hopefully, not too long to read or too complex for a non-English speaker to understand

**slackula** · 27-04-2010, 02:19 PM

^ I think this is it, 1100+ pages of light bedtime reading..

http://banking.senate.gov/public/_fi...O09D44_xml.pdf

**Butterfly** · 27-04-2010, 02:25 PM

^ oh boy

**sabang** · 27-04-2010, 02:28 PM

Originally Posted by Butterfly

sab, do you have a link of the entire bill ?

Nope- I'm just reading News reports, from hopefully credible sources. I think the proposed bill would be a monster to read actually. Couldn't pay me enough.

Originally Posted by Butterfly

OTC is "unregulated" for a very good reason, it creates flexibility and it's needed to cover certain risks.

That was the old investment bank argument- able to create bespoke contracts for specific situations and suchlike. But look at the mess it landed the banking sector and economy in- the large Investment banks and AIG only survived by being bailed out. So I think regulation is definitely needed, although whether everything can be traded via Exchanges is indeed arguable.

Originally Posted by sabang

non- contingent (futures type) contracts

Originally Posted by Butterfly

Futures are non-contingent

Don't get your point?

**sabang** · 27-04-2010, 02:34 PM

Originally Posted by Butterfly

In options, there is no settlement,

Whoo, hang on a bit- if you Sell (as opposed to buy) an Option, there is indeed a settlement owing at expiration if it goes against you. If you sell Call options naked, that liability is theoretically unlimited.
Can be pretty nasty selling Puts too.

**Butterfly** · 27-04-2010, 02:57 PM

Originally Posted by sabang

Nope- I'm just reading News reports, from hopefully credible sources. I think the proposed bill would be a monster to read actually. Couldn't pay me enough.

I went superficially over it, until page 400, my eyes hurt, the format with the big character is difficult to read. An interesting section regarding Swaps. Swap dealers will need to be registered with FIRA, probably disclose their holdings or their contracts but it wasn't clear. At any time FIRA can ask the financial participant to disclose all their "holdings".

It does sound ambitious, and frankly, not really feasible, would need 10,000 government employees to control all these "contracts" and "deals". Obviously this would become a cost issue

would need an educated summary by some specialist, for now it's unreadable, and it address everything from the employment of the agency to the budget financing etc...

**sabang** · 27-04-2010, 03:04 PM

Originally Posted by Butterfly

would need an educated summary

Indeed. It's a monster piece of Legislation in it's complexity- not too sure if they can get it right in one hit.

**Butterfly** · 27-04-2010, 03:08 PM

Originally Posted by sabang

Whoo, hang on a bit- if you Sell (as opposed to buy) an Option, there is indeed a settlement owing at expiration if it goes against you.

A call option has a payoff, it's not a settlement between party like we have with Forwards, it's a daily "marked to market" settlement at the Exchange. For a few assets, there might be "physical delivery" but I am not even sure this is the case in the Exchange. Oh almost forgot, it also depend if you are using American or European options. For technical reasons (opportunity cost), American options can't be less than European, so at the end it's the same. With European options though, the option can only be exercised at expiration, so it's definitely a bet. You can exercise earlier with Americans, but why would you when the alternative European on the same underlying, priced higher, wouldn't. Not going to demonstrate the pricing mechanism behind this. But I will need to check for the delivery and exercising facility, that's something I need to review, can't remember.

Obviously the payoff happens at the expiration for European options.

**Butterfly** · 27-04-2010, 03:20 PM

Originally Posted by sabang

there is indeed a settlement owing at expiration if it goes against you. If you sell Call options naked, that liability is theoretically unlimited.
Can be pretty nasty selling Puts too.

when it goes against you, that is out of the money, the option price is 0, and you are not going to exercise it.

let me find a few sources I have on the topic of Options strategy, it's quite difficult to remember it all.

**sabang** · 27-04-2010, 03:25 PM

Originally Posted by Butterfly

For a few assets, there might be "physical delivery"

Very rarely, if ever in practise- but you'd know that. Just pointing out the Option buyer just pays his premium and wins or loses- thats the end of his liability. The Option seller however collects this premium (minus commission or market making fees)- but then may have to cough up a lot more down the track. In this regard, the option seller resembles a futures/forwards contract buyer. Don't think it's pertinent here to go into different types of options and marking to market.

**sabang** · 27-04-2010, 03:29 PM

Originally Posted by Butterfly

Originally Posted by sabang

there is indeed a settlement owing at expiration if it goes against you. If you sell Call options naked, that liability is theoretically unlimited.
Can be pretty nasty selling Puts too.

when it goes against you, that is out of the money, the option price is 0, and you are not going to exercise it.

^ Nope, thats only the limited liability of the Option buyer, which is half of the market. Typical futures jockey

- check out Options 101, you'll quickly see what I mean about selling options. And for every buyer of an options contract- be that a Put or a Call- there is also a seller. I used to be one. It's mostly an Institutional market.

**Butterfly** · 27-04-2010, 03:38 PM

Originally Posted by sabang

In this regard, the option seller resembles a futures/forwards contract buyer.

definitely not, you must be thinking of something else.

Originally Posted by sabang

Typical futures jockey - check out Options 101, you'll quickly see what I mean about selling options.

The liability is precisely limited, that's Options 101, again I think you are confusing options with something else. I don't trade specifically options btw so I will need to look at my notes to make a more meaningful response, as I can't from memory.

**sabang** · 27-04-2010, 03:42 PM

Originally Posted by Butterfly

I don't trade options btw.

No you don't, and seriously neither do you know about them (which is no crime). You are out of your depth here BF.

Again, the seller (also known as the Writer) of a Call option contract has a potentially unlimited liability. The seller of a Put option contract also has a potential (but not unlimited) liability that well exceeds the Premium he received (ie that the option buyer paid).

In the real world, a naked (aka uncovered) options writer (ie seller) receives a quite attractive ongoing income stream, but every now and again is hit with a large loss. Which is why it is largely a professionals market

**Butterfly** · 27-04-2010, 07:39 PM

Originally Posted by sabang

No you don't, and seriously neither do you know about them (which is no crime). You are out of your depth here BF.

Again, the seller (also known as the Writer) of a Call option contract has a potentially unlimited liability. The seller of a Put option contract also has a potential (but not unlimited) liability that well exceeds the Premium he received (ie that the option buyer paid).

In the real world, a naked (aka uncovered) options writer (ie seller) receives a quite attractive ongoing income stream, but every now and again is hit with a large loss. Which is why it is largely a professionals market

After rechecking my notes on that topic, shorting a call without buying the underlying has indeed an "undefined" loss, but since price don't go to infinity, you are still limited to the loss between the Strike and the market price less the premium received. This is true for underwriting "naked call", or uncovered call. I have a long bias, so yes shorting options is something out of my usual sphere

as for being long a put (right to sell), if I am not mistaken, your loss is limited to the difference between the premium and the intrinsic value of the option at expiration. Yes liabilities exist, but they are not "unlimited" as you claimed. The risk does reside with the short, hence the need for the premium, but limits do exist, even if some can't be computed but they are bounded by the market price and the strike.

Hope that was clear

**Butterfly** · 27-04-2010, 07:43 PM

Originally Posted by sabang

In this regard, the option seller resembles a futures/forwards contract buyer.

after checking my notes, definitely not, at least presented as it is above. Like I said, maybe you meant something else. The only thing I could find ressembling what you are trying to say was the following:

An option in which the underlying is not an asset, that is on a Futures, will have the same intrinsic value at expiration as an option on the underlying of the Futures if they BOTH expire at the same time.

Is that what you meant ?

**sabang** · 27-04-2010, 10:05 PM

Originally Posted by Butterfly

long a put

Short a Put, dear boy. Aka writing, aka selling a Put.

Originally Posted by Butterfly

yes liabilities exist, but they are not "unlimited" as you claimed.

I claimed the opposite- the maximum loss for writing a Put is finite, it is in fact defined by the value of the underlying commodity or share that you wrote that Put on dropping to Zero.

It is writing a Call option that has theoretically unlimited liability, because the potential upside of a share or commodity is theoretically unlimited.

Back to those notes,

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