07 Aug 2014

Money Doesn’t Really “Go Into” Other Financial Assets

Banking, Shameless Self-Promotion 3 Comments

This is one of those posts where I’m really nit-picky about commentary that typically comes from people on “my side.” Not trying to tear people down, just trying to raise the bar on precision of language. An excerpt:

[A] booming stock market doesn’t actually mean that there is an accumulation ofactual money in Manhattan. For one thing, stock prices are set on the margin. If XYZ stock has 1 million outstanding shares and is originally trading at $100, and Smith comes along and spends $120,000 buying 1,000 shares of XYZ from a previous owner, then the price of XYZ just jumped 20%, causing the total “market cap” to jump by $20 million. It’s not as if $20 million in currency just “went into” XYZ. No, it was the transfer of a mere $120,000 that did the trick, and even there, the $120,000 in actual money isn’t going to now be “in” the company XYZ, or even in the possession of the previous owner of the stock (for very long).

3 Responses to “Money Doesn’t Really “Go Into” Other Financial Assets”

  1. Jan Masek says:

    I agree with the notion of being precise. That’s why i adore Dr. Kinsella (in a different field). However, not too sure here what the point is. Surely Wallstreet DOES have more actual money in their cash balances than they otherwise (absent Ben/Janet printing) would have?

  2. Major.Freedom says:

    Good point about what “a rise in the stock market” really means.

    Another one that is often misunderstood: The size of the derivatives market. This one gets me so frustrated. I see it almost non-stop. This blogpost is typical:


    People who don’t understand derivatives take that $700 trillion or $1,200 quadrillion number, compare it to GDP, and conclude “The size of the derivatives market is a huge threat to the world economy.”

    They even write the word that is supposed to make it clear the $1,200 quadrillion isn’t an actual dollar exchange value: “NOTIONAL”. That word is key. The notional amounts of derivatives contracts are used for nothing more than calculating actual payments based on agreed upon interest rates or other yield measures.

    For example, if A and B agree to an interest rate swap contract, which is a “derivative”, where A agrees to pay a fixed rate of 2%, and B agrees to pay LIBOR, for one year, “based on a notional amount of $1 billion”, then while the “size of the derivatives market” has just increased by $1 billion, the actual dollar amounts being exchanged is 2% of $1 billion or $20 million fixed going one way, and LIBOR*$1 billion variable going the other way. The $1 billion is just a reference number. It can be 100 times bigger with 100 times lower interest rates, and the same $20 million would be exchanged but the derivatives market just went up $100 billion!

    If you take the total “size of the derivatives market”, of $1,200 quadrillion or whatever, the actual amounts being exchanged are relatively small compared to this “notional” amount.

    Every time you see a blogpost or article where the author freaks out over the “notional” size, right away you know you are reading an article by someone who doesn’t understand derivatives.

    • Bogart says:

      Good point. This is one of the least understood things about the economy. The size is not in any way relevant. The only relevant issue is who is on the side of the derivative contract that is assuming the risk in the future and can that person pay the full terms of the contract. Of course in the 2008 housing derivative market, only central banks could uphold the end of this contract as they are the only ones that could make their own money.

      But if you backup the contracted counter party AIG in many cases or the US Gov directly in the cases of Fannie and Freddy then you of course have a disaster.

      But don’t worry the Fed and Gov at the time guaranteed that these problems were in paper only and would affect the economy at large. Furthermore they will never again backup an insurance company like AIG.

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