Derivative systems
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The power of derivative systems

Summary
Satyajit Das uses an Indonesian company's derivative trades to introduce us to the workings of the international derivatives system.  Das describes the components of the value delivery system and the key transactions.  He demonstrates how the system interacted with emerging economies expanding them, extracting profits and then moving on as the induced bubbles burst.  Following Das's key points the complex adaptive system (
This page introduces the complex adaptive system (CAS) theory frame.  The theory is positioned relative to the natural sciences.  It catalogs the laws and strategies which underpin the operation of systems that are based on the interaction of emergent agents. 
John Holland's framework for representing complexity is outlined.  Links to other key aspects of CAS theory discussed at the site are presented. 
CAS
) aspects are highlighted. 
Traders guns and money
In Satyajit Das's book 'Traders guns and money' he outlines the derivative value delivery system that
This page discusses the mechanisms and effects of emergence underpinning any complex adaptive system (CAS).  Key research is reviewed. 
emerged
after the creation of derivative contracts.  A variety of types of derivatives and their risk profile are described. 

Das uses a set of related foreign currency transactions with an Indonesian company during the 1990s Asian economic boom as an illustration of derivatives in action. 

To set the scene - foreign investment and loans were flooding into Asia in the 1990s.  It was part of a repeating process of integrating developing economies into the western financial system.  Das identifies four phases:
  1. The World Bank was setup as part of the Bretton Woods agreements, as the International Bank for Reconstruction and Development, to repair and reconstruct Europe after the Second World War and provide reconstruction and development resources for projects in developing economies.
    had pushed the countries to deregulate to attract foreign investment.  Government controls were relaxed.  Local labor costs were low.  There were no employment laws.  Abundant natural resources were available.  The local markets were opening up.  But political instability and no social welfare system forced people to save money (especially in Swiss accounts).  The costs of office space sky rocketed.  Phones and plumbing didn't work.  Traffic was terrible. 
  2. Living standards improve for the fortunate.  Property and share prices climb steeply.  More money flows in.  Local banks relax lending standards. Foreign banks lend to local banks.  Investors enter the market. 
  3. Costs rise to levels that make the economy uncompetitive.  Politicians discuss moving up the value chain.  Major initiatives are launched.  The bubble pulls in more investment. 
  4. The new economy collapses.  
The international bankers and traders fuelled each boom with new issues of shares and bonds sold to investors.  They gained commissions trading the securities to foreign investors.  They had produced derivative products which the Asian companies and investors had snapped up. 

The foreign currency derivative transaction is an operation which guarantees to complete a defined set of activities or return to the initial state.  For a fee the postal service will ensure that a parcel is delivered to its recipient or will return the parcel to the sender.  To provide the service it may have to undo the act of trying to deliver the parcel with a compensating action.  Since the parcel could be lost or destroyed the service may have to return an equivalent value to the sender. 

In the 1990s the client, an Indonesian company, produced and sold product in Indonesia, but with the global integration they concluded it would be cheaper to obtain finances from the global market.  The Indonesian currency is legal tender which provides no interest payments to the holder.  It is a central aspect of money and in CAS is an analog of a short term potential energy token such as the high energy phosphate bond of the base ATP.  But the interaction of the geometric breeding and deaths of agents that perform actions and the linear increase in real resources, described by Turchin, results in the correspondence between energy and currency being complex and adaptive. 
was costing 12% for loans while the dollar was only 6%.  Investment banks were happy to assist.  The client entered into derivative contracts.  With the Indonesian currency pegged to the dollar there appeared to be no currency risk, is an assessment of the likelihood of an independent problem occurring.  It can be assigned an accurate probability since it is independent of other variables in the system.  As such it is different from uncertainty. 


The initial derivatives the company used were swaps:
The bank then told them that the dollar yield curve, plots yield to maturity(y) against time to maturity (x) with the expectation that yield will be higher for debt instruments with longer times before they mature.  Price risk is also typically higher on longer maturity debt.  However when short term interest rates are rising the short term yield will rise faster than the long term yield and the shape of the yield curve can become inverted. 
was steep and that they would benefit from a contract change.  So they added an arrears reset swap:
  • The company agrees to pay for dollars at LIBOR - 0.4% at an interest rate set in arrears (actually 2 days before the end of the 6 month period of the contract).  
When the bank said the dollar yield curve was flattening they cancelled the arrears reset swap making a profit.  Probably when the dollar interest rate moved the trader no longer wished to be in the contract. 

The company entered into a swap to fix the cost of the dollar payments, under the assumption that the dollar rate would rise.  By trading in and out they had made another profit. 

The company then entered into a 'double up' swap:
  • The company would pay fixed rates in dollars for five years.  But interest rates for five years were higher than for six months.  So the companies cost of borrowing would be higher.  To make that cost cheaper, the company placed a bet - They were offered a lower borrowing cost but with some strings attached.  If dollar rates went up, then the fixed rate would convert to a floating one.  If the dollar went down then the deal ($300 million) would double in size ($600 million).  There was also a hidden currency option in the contract.  The exchange rate for the second $300 million was fixed at the original exchange rate. 
While this contract reduced the borrowing costs it made no sense for the company to enter into.  Any protection, they thought they had obtained, against dollar rates changing, was contractually removed just when they needed it!  The company had no control over the factors that could now impact them hugely.  However, the Federal Reserve of 1913 was a response to a series of banking panics with the goal of responding effectively to stresses.  It setup:
  • At least 8 and not more than 12 private regional Federal Reserve banks.  Twelve were setup
  • Federal Reserve Board with seven members to govern the system.  The President appointed the seven, which must be confirmed by Congress.  In 1935 the Board was renamed and restructured. 
  • Federal Advisory Committee with twelve members
  • Single US currency - the Federal Reserve Note. 
did. 

Das claims that investment banks typically initiated deals with a customer with a small win (Twinkie) for the customer.  Only later when the customer had built trust and distrust are evolved responses to sham emotions.  During a friendship where no sham emotions have been detected trust will build up. 
and assumed they were going to get more profits from further contracts would the hidden hooks appear.  Even when the customer lost money they would come back for more. 

Who understood what was happening?  Das discusses the accounting
The agents in complex adaptive systems (CAS) must model their environment to respond effectively to it.  Samuel modeling is described as an approach. 
model
s that banks are required to use.  Mark-to-market accounting attempted to link the various derivative products to their market values.  But since over-the-counter products could be unique, models were used to derive the value.  Dealers liked mark-to-market since it allowed income to be booked up front.  That introduces risk, is an assessment of the likelihood of an independent problem occurring.  It can be assigned an accurate probability since it is independent of other variables in the system.  As such it is different from uncertainty. 
, since the other party may not pay, so the banks are required to keep cash reserves.  Das explains that the subjective nature of the valuations makes reserves a potential slush fund for profit smoothing - which produces bank results that are attractive to investors.  Regulators and law makers control the accounting models but the nature of futures introduces estimations into the valuation process.  Accountants wanted to limit reserves (slush funds).  Regulators wanted to expand them.  Traders went with the accountants - they reported more income and obtained larger bonuses!

Often all three parties to a swap like the result:  A company can trade variable interest rate debt for fixed rate debt.  When interest rates are volatile this is a good hedge.  For that risk reduction the issuer of the fixed rate debt can obtain access to variable rate debt at an especially low price.  The bank obtains transaction fees and maybe more.  Over time the competition between banks and the goal of increasing transaction volume would push each new derivative product into a commoditized product processed in bulk by a warehouse.  There were no arrangement fees.  Banks profited from the spread between the bid and offer.  The products were easily reverse engineered.  Commoditization and competition ensured the need for volume.   To improve the potential for profits traders would take open positions rather than hedge the derivatives. 

Das comments that swaps that hedged interest rate and currency risk, is an assessment of the likelihood of an independent problem occurring.  It can be assigned an accurate probability since it is independent of other variables in the system.  As such it is different from uncertainty. 
created opportunities as countries started to open up their markets.  The various currencies and financial systems allowed investors to find undervalued currencies providing them with access to low cost capital is the sum total nonhuman assets that can be owned and exchanged on some market according to Piketty.  Capital includes: real property, financial capital and professional capital.  It is not immutable instead depending on the state of the society within which it exists.  It can be owned by governments (public capital) and private individuals (private capital). 


Enabling the Japanese investor in the 1980
Japan was particularly attractive for banks and issuers.  Byzantine investment rules, mostly unwritten and obscure, prevented investors from investing where they wanted. Investment banks and issuers devised structures to circumvent the rules. 

Japanese investors were limited in the amount of foreign currency is legal tender which provides no interest payments to the holder.  It is a central aspect of money and in CAS is an analog of a short term potential energy token such as the high energy phosphate bond of the base ATP.  But the interaction of the geometric breeding and deaths of agents that perform actions and the linear increase in real resources, described by Turchin, results in the correspondence between energy and currency being complex and adaptive. 
bonds they could buy, but a bond denominated in a foreign currency issued by a Japanese entity was not a foreign currency bond under the rules.  In 1985 Long Term Credit Bank a AAA rated Japanese lender entered a contract with Bankers Trust for a bond with a 1% higher interest rate than normal.  In return the investors, Japanese insurance companies took on uncertainty is when a factor is hard to measure because it is dependent on many interconnected agents and may be affected by infrastructure and evolved amplifiers.  This is different from Risk.   if the yen rose above 169 to the dollar over the next 10 years.  If it reached 84.5 to the dollar the investors lost their entire principal. 

Similarly Japanese investors liked US$ zero coupon bonds.  These pay no interest over the 10 year period but then pay the principal and compounded interest in one sum.  If the Japanese yen fell (the bank of Japan policy kept the yen weak) the final dollar payment was amplified in terms of yen.  Further while the initial bond investment was a payment the final repayment was classed as a capital is the sum total nonhuman assets that can be owned and exchanged on some market according to Piketty.  Capital includes: real property, financial capital and professional capital.  It is not immutable instead depending on the state of the society within which it exists.  It can be owned by governments (public capital) and private individuals (private capital). 
gain which was not taxed in Japan at the time. 

In December 1985 at the Plaza Accord, the Reagan administration got the agreement of the G7 is the group of seven: Canada, EU, France, Germany Italy, Japan, UK, US.    central bankers that the Bank of Japan would let the yen float.  The yen rose dramatically an appreciation of 310% at its peak.  The Japanese investors, who had always assumed the Bank of Japan would keep the yen weak to help the countries exporters suffered huge derivative losses. 

The long term effect of the yen appreciation was to push the Japanese economy into depression.  The central bank dropped interest rates to 0.  Japanese insurance companies had written policies with guaranteed interest of 3-4%.  The economy would not allow their businesses to generate that.  US investment banks were happy to offer derivative products (reverse dual currency bonds) that might help them generate that capital.  Ordinary Japanese investors were also getting 0% interest on their savings.  They also headed for reverse dual currency bonds. 

Black-Scholes can solve the contingent investment discount rate dilemma for pricing options.  It establishes a tracking portfolio with the same payoffs as the option and dynamically tracks the portfolio as the stock price evolves, adjusting the value of the option.  It is argued that the adjustment ensures the rate of return to a hedge position remains constant over time. 
option pricing allowed derivatives products to be built around options.  The contracts used the models to hedge the risk, is an assessment of the likelihood of an independent problem occurring.  It can be assigned an accurate probability since it is independent of other variables in the system.  As such it is different from uncertainty. 
but the models were not perfect and in Oct 1987 US stock markets collapsed.  Option books failed badly.  The models had proved poor approximations of markets in meltdown. 

Das points out that the former Federal Reserve of 1913 was a response to a series of banking panics with the goal of responding effectively to stresses.  It setup:
  • At least 8 and not more than 12 private regional Federal Reserve banks.  Twelve were setup
  • Federal Reserve Board with seven members to govern the system.  The President appointed the seven, which must be confirmed by Congress.  In 1935 the Board was renamed and restructured. 
  • Federal Advisory Committee with twelve members
  • Single US currency - the Federal Reserve Note. 
chairman Alan Greenspan argued that derivatives allow banks and non-banks to unbundle risks and thereby enhance the process of wealth is schematically useful information and its equivalent, schematically useful energy, to paraphrase Beinhocker.  It is useful because an agent has schematic strategies that can utilize the information or energy to extend or leverage control of the cognitive niche.  
creation. 

In the 1990s Greenspan's low interest rate policies, government regulatory requirements and pension privatization strategies, consistent economic growth, escalating real estate prices, and the shaky financial position of many banks drove investment managers, flush with cash, to seek safer and higher returns in the financial markets.  The excess of capital enabled hedge fund is an investment fund that accepts investments from a limited number of accredited individual or institutional investors.  Hedge funds are able to use investment methods that are not allowed for other types of fund. 
s to operate as investment vehicles. 

The derivative
The complex adaptive system (CAS) nature of a value delivery system is first introduced.  It's a network of agents acting as relays. 

The critical nature of hub agents and the difficulty of altering an aligned network is reviewed. 

The nature of and exceptional opportunities created by platforms are discussed. 

Finally an example of aligning a VDS is presented. 
value delivery system

The buy side - are customers, corporations and investors who trade derivatives with investment banks.  They do it to hedge risk, is an assessment of the likelihood of an independent problem occurring.  It can be assigned an accurate probability since it is independent of other variables in the system.  As such it is different from uncertainty. 
, manage exposure or speculate.  Money managers need to match or beat their competitors.  They often do that by investing a large proportion of their funds in the market (index funds) and then a small proportion in a hedge fund is an investment fund that accepts investments from a limited number of accredited individual or institutional investors.  Hedge funds are able to use investment methods that are not allowed for other types of fund. 
where they hope to obtain a higher return. 

The sell side - Investment bank traders, who can trade over-the-counter with buyers, or at the exchanges, and their support staff: sales team, research analysts, risk managers, product controllers, compliance officers, lawyers, quantitative analysts and other back-office staff.  Traders make prices for the sales teams to show their clients.  If the client accepts, the trader must then buy the asset - hopefully at a lower cost than the price he set.  Traders unbundle derivatives and cover each part in a trade.  Traders can also trade for their own accounts - to do that successfully they must know the future.  Das writes trading strategies include: overwhelming force, ganging up, ambush (inside information)!  The contractual nature of the products requires the lawyers to accurately assess the courts positions. 

The exchanges - Dealers match buyers and sellers of commoditized derivative products, charging a fee on the transaction. 

Warehouses - Investment banks entered into trades with clients as principals, allowing immediate execution, but adding to the banks risk, is an assessment of the likelihood of an independent problem occurring.  It can be assigned an accurate probability since it is independent of other variables in the system.  As such it is different from uncertainty. 
.  The assumption was that banks could enhance earnings from trading and managing the risks of the mismatches.  Actually warehousing, is a loan extended from a large bank or Wall Street firm to a nonbank to originate mortgages. 
turned the traded derivatives into undifferentiated commodities and typically exchanged profit for volume. 

Product groups - include arbitrage teams who leverage the models and analytics to identify inefficiencies.  These inefficiencies can be exploited by creating derivatives contracts which traders could bet with. 

Quantitative analysts - Produced the models that, for example, match one item in a forward with the market benchmark, the analytics that identify market inefficiencies, and the technologies. 

Accountants - model the operation of the banks, assessing assets and allocating cash flows, revenues and profits to particular accounts. 

Academics - Guardians of the theories leveraged to develop the models, and create the derivative products, and legal frameworks that enable the
This page discusses the effect of the network on the agents participating in a complex adaptive system (CAS).  Small world and scale free networks are considered. 
network
of
Plans are interpreted and implemented by agents.  This page discusses the properties of agents in a complex adaptive system (CAS). 
It then presents examples of agents in different CAS.  The examples include a computer program where modeling and actions are performed by software agents.  These software agents are aggregates. 
The participation of agents in flows is introduced and some implications of this are outlined. 
agents
to emerge and operate.  

Hedge fund is an investment fund that accepts investments from a limited number of accredited individual or institutional investors.  Hedge funds are able to use investment methods that are not allowed for other types of fund. 
s and financiers - Hedge funds charge investors a fee and a share of the profits.  They are allowed to perform trades that typical investors can't - short selling is a multi part transaction where:
  • A borrowed tradable asset (this part of the transaction is not performed in the naked version) is sold under the assumption that the asset is going to fall in price during the period when it has been borrowed. 
  • Once the asset falls in price it is then purchased. 
  • The asset is returned to the lender, with any additional risk premium. 
  • The short seller keeps any profit.  If the asset gained value during the period of the short then the seller makes a loss.  
and leveraged trades.  Those trades require derivatives.  They may arbitrage two similar assets that are differently priced and wait for the prices to equalize.  To make big money these small differences must be leveraged.  The assumption is that the market models available to the hedge funds limit the risk of mistakes! 

Regulators - Global agents such as the World Bank was setup as part of the Bretton Woods agreements, as the International Bank for Reconstruction and Development, to repair and reconstruct Europe after the Second World War and provide reconstruction and development resources for projects in developing economies.
.  Western economy's central banks: the US is the United States of America.   Federal Reserve system of 1913 was a response to a series of banking panics with the goal of responding effectively to stresses.  It setup:
  • At least 8 and not more than 12 private regional Federal Reserve banks.  Twelve were setup
  • Federal Reserve Board with seven members to govern the system.  The President appointed the seven, which must be confirmed by Congress.  In 1935 the Board was renamed and restructured. 
  • Federal Advisory Committee with twelve members
  • Single US currency - the Federal Reserve Note. 
in particular, and US market regulators such as the regulators of the Chicago Mercantile Exchange. 

Derivatives and risk
The forward contract hedge
A farmer with no support subsidies who has invested in a field of wheat, is exposed to price risk, is an assessment of the likelihood of an independent problem occurring.  It can be assigned an accurate probability since it is independent of other variables in the system.  As such it is different from uncertainty. 
(supply & demand), and potentially volume risk.  To control the price risk the farmer can sell the wheat forward for an agreed price.  By giving up wind fall profits of a high price the farmer hedges against a low price.  Typically the agreed sales price is created by pre-selling a future share of an 'equivalent' market benchmark product.  At the time of the future sale the benchmark product is purchased offsetting the price change in the wheat.  At the time of the actual sale the actual wheat and the bench mark may have moved out of alignment so there is still some 'basis' risk.  It depends how good a model for the wheat the benchmark future is. 

When interest rates are high and volatile (1980) currency is legal tender which provides no interest payments to the holder.  It is a central aspect of money and in CAS is an analog of a short term potential energy token such as the high energy phosphate bond of the base ATP.  But the interaction of the geometric breeding and deaths of agents that perform actions and the linear increase in real resources, described by Turchin, results in the correspondence between energy and currency being complex and adaptive. 
transactions can be hedged. 

You can speculate with forward contracts betting that the price will rise while buying forward, or that it will fall while selling forward.  It can create leverage since the dealer may only require a deposit on the transaction. 

Borrowers demand money at the lowest prices.  Swaps allowed them to exploit anomalies between capital is the sum total nonhuman assets that can be owned and exchanged on some market according to Piketty.  Capital includes: real property, financial capital and professional capital.  It is not immutable instead depending on the state of the society within which it exists.  It can be owned by governments (public capital) and private individuals (private capital). 
markets to raise cheaper funds.  They would raise money in a currency with a low interest rate, while charging their direct investors a premium, and then swap the currency for the one they really needed. 
Derivative put option
The farmer can attempt to capture a high future price while 'insuring' against a low price with a put option is an agreement, covering a stated period of time, by the put option seller to pay the put option buyer the option price if required, for the asset the buyer owns, even if this underlying asset has a lower current value in the market.  The seller of the put option is paid a premium for providing the 'insurance'. 
.  The contract agrees that
  • If prices fall below the strike price the seller of the option makes up the difference.  He does this because
  • The farmer will pay a premium for the 'insurance'.  

Derivative call option
Call options provide the equivalent 'insurance' on a rise in price. 

Buying options limits your losses to the option premium paid.  Selling options limits your gain to the premium while the potential loss is unlimited. 

Derivative short sell
Contractually agreeing to sell a product or commodity at an agreed price in the future locks in the price, but the seller does not need to own the item is where a tradable asset is sold short but no arrangement is made to ensure the asset can be borrowed.  The SEC has banned the practice in the US.  But traders and hedge funds may take a risk to ensure their goal is achieved, may use an exchange in a country that allows naked trades, or use the court system to avoid punishment.  .  If the actual price has dropped at the contracted time of sale then the item can be purchased at the time and then sold on for a profit.  If the price has risen then a loss ensues. 

Since the product or commodity shorted is a multi part transaction where:
  • A borrowed tradable asset (this part of the transaction is not performed in the naked version) is sold under the assumption that the asset is going to fall in price during the period when it has been borrowed. 
  • Once the asset falls in price it is then purchased. 
  • The asset is returned to the lender, with any additional risk premium. 
  • The short seller keeps any profit.  If the asset gained value during the period of the short then the seller makes a loss.  
is not owned is where a tradable asset is sold short but no arrangement is made to ensure the asset can be borrowed.  The SEC has banned the practice in the US.  But traders and hedge funds may take a risk to ensure their goal is achieved, may use an exchange in a country that allows naked trades, or use the court system to avoid punishment.  , no capital is the sum total nonhuman assets that can be owned and exchanged on some market according to Piketty.  Capital includes: real property, financial capital and professional capital.  It is not immutable instead depending on the state of the society within which it exists.  It can be owned by governments (public capital) and private individuals (private capital). 
is required to commit to the sale.  The transaction has leverage.  How much depends on the margin required by the dealer in accepting the trade. 

Derivative swaps
Swaps allow one series of future cash flows to be exchanged for a different series of cash flows.  While initially traded at exchanges these contracts were allowed, in the late 1970s, to be traded in the over-the-counter (OTC) market, including cash settlements.  That allowed the emergence of a network of banks and non-banks creating, selling and trading the contracts. 

Large transactions that would disturb the currency is legal tender which provides no interest payments to the holder.  It is a central aspect of money and in CAS is an analog of a short term potential energy token such as the high energy phosphate bond of the base ATP.  But the interaction of the geometric breeding and deaths of agents that perform actions and the linear increase in real resources, described by Turchin, results in the correspondence between energy and currency being complex and adaptive. 
markets, and typically drive up the interest rate could be virtualized as swap contracts between organizations which were seeking the flows.  IBM and the World Bank was setup as part of the Bretton Woods agreements, as the International Bank for Reconstruction and Development, to repair and reconstruct Europe after the Second World War and provide reconstruction and development resources for projects in developing economies.
used a pair of such flows in a currency swap so IBM could sell huge volumes of Swiss and German currency it had accumulated at a profit and the World Bank could buy them at low interest rates.  IBM paid the World Banks dollar bond obligations while the World Bank paid IBMs Swiss/German bond obligations.  Salomon made a lot of money setting up the transaction. 

Speculation on the future values was argued to increase the liquidity of the markets. 

Regulatory arbitrage
Since the resolution of a derivative contract is in the future it has no current accounting value, making the contract off balance sheet.  Similarly the contract may never require ownership of the traded commodity, removing the transaction from the control of the commodity regulator.  Indeed, stock awards that limit selling for a period of time can be circumvented with a forward sale contract on the stock. 

As significant was the potential to avoid exchange controls and tariffs.  A swap would allow future foreign exchange flows to be contractually matched with local currency flows.  The investment bank would find a second company that wished to do the opposite transaction.  Both companies would avoid the taxes. 

Credit derivatives allowed banks to offload credit, and hence reuse capital is the sum total nonhuman assets that can be owned and exchanged on some market according to Piketty.  Capital includes: real property, financial capital and professional capital.  It is not immutable instead depending on the state of the society within which it exists.  It can be owned by governments (public capital) and private individuals (private capital). 
.  Credit was historically legally tied to a bank.  It was difficult to trade and tied up capital.  Credit derivatives could solve that problem.  When interest rates are low and credit margins thin investors want yield enhancement.  Buying a high interest bond linked to a portfolio of Japanese bank A rated bonds seemed attractive.  If any of the Japanese banks defaulted on their obligations the investor suffered a loss, since they got the Japanese bonds of the defaulting bank (with a 40% of face value) rather than their investment.  But the combined probability of the first to default actually made the bond a BBB-.  The first to default condition was also leveraged.  While the loss is limited to the face value of the bond the risk, is an assessment of the likelihood of an independent problem occurring.  It can be assigned an accurate probability since it is independent of other variables in the system.  As such it is different from uncertainty. 
taken on is five times that.  If the default correlation of the banks is low this also means more risk for the investor.  The bond issuer had removed the credit risk from their books even though they nominally still held the Japanese bonds. 

The breakthrough credit derivative was the credit default swap (CDS is a credit-default swap, nominally insurance where the buyer of the CDS gets paid if the subject of the swap can't meet its obligations.  It appears to be insurance but insurance companies must set aside reserves to handle such claims.  Britain initially required that insurance buyers also have an insurable interest.  That is required in insurance markets to ensure buyers of insurance don't destroy their asset just to obtain the insurance.  CDS were not required to do the same, because it was decided they were not insurance which encouraged such abuses and risk taking.  Stocks could be sold short when they were backed by CDS.  And the swap market is limited making it easy to undermine its liquidity.  They carry considerable risk because:
  • They are governed by the CFMA, which ensures they are unregulated and opaque
  • The incentives encouraged problems - the more CDS you own the more you benefit from [causing] problems with the 'insured' assets.  And unlike traditional insurance you could buy as many CDS as you could afford. 
).  Here a bank sells the uncertainty is when a factor is hard to measure because it is dependent on many interconnected agents and may be affected by infrastructure and evolved amplifiers.  This is different from Risk.   on a loan to a buyer for a fee.  The investor agrees to indemnify the bank against losses if the loan taker fails. 

The key credit derivative is the collateralized debt obligation (CDO is a:
  • Care delivery organization in health care. 
  • Collateralized debt obligation in finance.  The idea is to transfer the credit risk rather than the loan itself.  The bank enters into a CDS on the loans with a SPV.  The CDO allows the bank to shift its loans outside the reach of regulators.  The CDO also can distribute the risk unevenly by tranching.  Equity is most at risk.  Then any subordinated debt. 
).  The idea is to transfer the credit risk, is an assessment of the likelihood of an independent problem occurring.  It can be assigned an accurate probability since it is independent of other variables in the system.  As such it is different from uncertainty. 
rather than the loan itself. 

The flexibility of a derivative contract ensured that each investor could match their desired risk, is an assessment of the likelihood of an independent problem occurring.  It can be assigned an accurate probability since it is independent of other variables in the system.  As such it is different from uncertainty. 
and reward profile to a tradable commodity.  The underlying assets could vary dramatically is when a factor is hard to measure because it is dependent on many interconnected agents and may be affected by infrastructure and evolved amplifiers.  This is different from Risk.  : management of liabilities, interest rates, currencies is legal tender which provides no interest payments to the holder.  It is a central aspect of money and in CAS is an analog of a short term potential energy token such as the high energy phosphate bond of the base ATP.  But the interaction of the geometric breeding and deaths of agents that perform actions and the linear increase in real resources, described by Turchin, results in the correspondence between energy and currency being complex and adaptive. 
, equities, emerging market local currency securities, credit eventually including mortgages; unfortunately the liquidity typically created a bubble in each new asset market which sucked in investors and then burst.  In 1995 Mexico experienced the Tequila crisis.  In 1997 the Asian century burst.  In 1998 Russia defaulted.  In 2001 Argentina collapsed.  In 2001 the CDO (credit) market collapsed. 

The application of
This page introduces the complex adaptive system (CAS) theory frame.  The theory is positioned relative to the natural sciences.  It catalogs the laws and strategies which underpin the operation of systems that are based on the interaction of emergent agents. 
John Holland's framework for representing complexity is outlined.  Links to other key aspects of CAS theory discussed at the site are presented. 
CAS theory
represents derivative contracts as a set of
This page discusses the mechanisms and effects of emergence underpinning any complex adaptive system (CAS).  Key research is reviewed. 
emergent
niches.  The investment banks could use legal contracts to create:
More broadly financial organizations can be viewed analogously to mitochondria are the energy molecule generating production functions of eukaryotic cells.  They are vestigial blue-green bacteria with their own DNA and infrastructure.  Unlike stand-alone bacteria they also use the eukaryotic host DNA and infrastructure for some functions.  The high energy molecules are nucleotides with a high energy phosphate bond.  The most used high energy molecule is Adenosine-tri-phosphate.  , with similarly powerful capabilities to:

It is clear that derivatives allow huge creativity, and
To benefit from shifts in the environment agents must be flexible.  Being sensitive to environmental signals agents who adjust strategic priorities can constrain their competitors. 
flexibility
in what actions can be induced.  


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integrating quality appropriate for each market
 
This page looks at schematic structures and their uses.  It discusses a number of examples:
  • Schematic ideas are recombined in creativity. 
  • Similarly designers take ideas and rules about materials and components and combine them. 
  • Schematic Recipes help to standardize operations. 
  • Modular components are combined into strategies for use in business plans and business models. 

As a working example it presents part of the contents and schematic details from the Adaptive Web Framework (AWF)'s operational plan. 

Finally it includes a section presenting our formal representation of schematic goals. 
Each goal has a series of associated complex adaptive system (CAS) strategy strings. 
These goals plus strings are detailed for various chess and business examples. 
Strategy
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This page uses an example to illustrate how:
  • A business can gain focus from targeting key customers,
  • Business planning activities performed by the whole organization can build awareness, empowerment and coherence. 
  • A program approach can ensure strategic alignment. 
Program Management
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