600,000,000,000,000?

By Sheridan, Barrett | Newsweek International, October 27, 2008 | Go to article overview

600,000,000,000,000?


Sheridan, Barrett, Newsweek International


Byline: Barrett Sheridan

It's a number no one questions, but the size of the derivatives market is not as shocking as it looks

If some banks are too big to fail, $600 trillion has become the number too big to question. That's $600,000,000,000,000--the rough figure cited in many news reports for the total size of the derivatives market, now blowing up to such alarming effect. At a time of mind-boggling turmoil on Wall Street, perhaps it's not surprising that few stop to ponder how a market for obscure financial products, or any product, could have quadrupled in size since 2002, and now measures more than 12 times the size of the world economy. How could any "market" rack up sales that dwarf the income of all nations combined? First of all, that $600 trillion figure is out of date, from the end of last year. Official figures haven't been released, but surveys reveal the market has now grown to at least $668 trillion. But the good news is that most of it is not real money. This market is at least a bit less incomprehensibly huge, and dangerous, than the 15-figure numbers suggest.

A little background: derivatives are exactly what they sound like--their worth is derived from something else. That something else could be General Motors stock or Morgan Stanley bonds or any number of other items. In a credit default swap, for instance, a hedge fund that loaned $10 million to Southwest Airlines might agree to pay 1 percent a year, or $100,000, to an investment bank. In return, the investment bank agrees to pay the hedge fund the full $10 million if Southwest goes bankrupt. When journalists print big, scary numbers like the $668 trillion figure above, they're referring to the "notional value," or the worth of the underlying assets--$10 million in the Southwest example. In almost every case, only a small sliver of that ($100,000 in this case) is real money changing hands.

"It's not a wrong number," says Stephen Figlewski, a professor of finance at NYU's Stern School of Business and founding editor of the Journal of Derivatives, of the hundreds of trillions. "But it's not at all comparable to the sort of things people are trying to compare it to, like the total amount of stock traded on the New York Stock Exchange. These numbers cannot be compared." Saying there's $668 trillion in derivatives floating out there is like saying every lottery ticket sold is worth the full value of the jackpot. If the jackpot is $100 million and lottery organizers sell 2 million tickets, "that's $200 trillion worth of lottery wealth that's circulating!" jokes Figlewski. "When you say it that way, everybody knows that's a complete nonsense number. …

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