Basic Finance Terms. Bonds. Debt. Yield/Return. Interest Rates. Risk. Derivatives are a Fancy Bet.
Terminology clarification. Debt is called credit is called a loan. So debt = credit = loan. Government debt is called a bond.
Bonds are a debt or IOU issued by a government or sovereign nation. The government takes your currency and promises to return it with a certain amount of interest (profit) in a certain time period. When you buy a bond, you become the bond holder. This means you are lending your currency to the government. You want that to be a responsible government that will pay back its debt, otherwise, this is a risky investment.Bonds have a purchase price and a time-dependent rate of return called the interest rate, or bond yield. So Return is the same as Interest Rate is the same as Bond Yield.
Bonds yields/return and purchase price usually have an inverse relationship. When bond yield goes up, bond purchase price falls. When bond yield falls, bond purchase price goes up.
Bond holders are rewarded for time. A short time period has low risk with less profit. A long time period has high risk with high profit.
So the yield/return of the debt reflects a.) length of TIME the debt is held, b.) the RISK associated with the debt (likelihood of payout) and c.) INCENTIVE to hold and not re-sell.
When a nation issues too much debt in the form of bonds, it means the government is taking on more risk. The yield/return goes up because the risk is higher. If I run the risk of not getting my money back, then I want to be compensated. Higher risk = higher rates.
High risk debt means you may not get your money back.
High risk means management is not making good decisions for the business.
High risk debt usually has a higher yield/return.
Low risk debt usually has a lower yield/return.
In a non-manipulated free market system, nations with a high debt to GDP ratio have high bond yield/return. This high interest return is compensation for the high risk of supporting a nation with high debt.
So, in general, a lower bond yield should indicate a nation with a low debt to GDP ratio. Exceptions: Negative bond yields indicate a different situation entirely. Some countries may have low debt and low GDP.
Bond yields trade based on inflation. Inflation is Loss of Purchasing Power or shrink-flation where you get less for the same price. ...If inflation rises, bond yields (interest returned) will do the same. And when bond yields rise, bond prices COLLAPSE. And when bond prices collapse, the bond bubble bursts.
[GainsPainsCapital.com]
In general, bond yield is determined by risk level. One factor for determining risk is the length of time for returning the currency. Another factor is the responsiblity and solvency of the person or institution issuing the debt. Will they pay their debt?
Short term interest rate return (profit or yield) for the bond holder is low. This is because the time period for risk is short. In general, long term interest rate return (profit or yield) for the bond holder is high since the time period for risk is long.
Another important factor to understand about interest rates is that they are part of the debt cycle in any fiat currency system. A cycle means a swing from higher prices to lower prices. Typically this happens in a 5-8 year time period. Central banks typically try to manage
this credit cycle.
...The most important thing you need to know about interest rates is that they are a price: the price of [paper-fiat] money. The price of money is a signal. If it's cheap, people and businesses tend to borrow. If it's expensive, people and businesses tend to save rather than spend and invest. The economy slows down, interest rates fall, credit gets cheaper and the cycle begins again...
~ Tim Price at MoneyWeek.com
Solvency means the items you own that have physical value. Solvency also means your current ability to pay back a loan.
This artificial pricing system for paper currency is dependent on the solvency of the government backing the paper currency. Solvency means that assets (physical items of value) are more than debt.
If a government does not have the assets to redeem (pay for) the value of a paper money note, the
paper note loses value.
~ Tim Price at MoneyWeek.com
So in general, and all else being equal, a high bond yield usually is a high risk investment indicating a nation with high debt. A low bond yield usually is a low risk investment indicating a nation with low debt.
Data below is from Dec, 2016. In a non-rigged financial system, nations with a high debt to GDP ratio should have high bond yields indicating their high-risk economic status. The numbers below indicate heavily manipulated bond markets in many countries.
What exactly is a derivative? Good question. This is an over-simplified answer.
Derivatives are a fancy bet written out as a legal contract. Typically based on an underlying index (a list of values such such as commodities or interest rates).
Many derivatives, potentially more than 80 percent, are related to interest rates.
Warren Buffet calls derivatives
financial weapons of mass destruction
. [PDF]
A quick disclaimer. This explanation is designed to give a non-financial person a good basic understanding of the topic. It does not go into detail.
The derivative contract specifies 1.) a specific time period 2.) a specific asset or commodity price or range and 3.) at least two parties signing the contract, the party and counter-party.
CopperTop Inc is a mining company that depends on a price of $3 per oz of copper to cover its operating costs and make a profit. If the price of copper falls under $3 per oz for any length of time, CopperTop Inc. will have trouble staying in business.
So CopperTop Inc goes out and buys a derivatives hedge to guarantee a steady income for a certain time period. CopperTop Inc. (the party) pays a fee to a broker-bank (the counterparty) for a derivatives contract.
The CopperTop Inc contract may specify ...for the next 6 months, CopperTop is guaranteed a copper price of
$3 per ounce...
If the price of copper is over $3, the broker-bank does not owe anything to CopperTop Inc.
However, if the copper price falls to $1 per ounce, the broker-bank must pay the difference to CopperTop Inc for
the time specified in the contract.
The broker-bank is betting that the price of copper will stay high for a certain length of time and that they can make a profit from the fee they charge. If the price drops below a certain point, the broker-bank must pay CopperTop Inc and will lose money.
So CopperTop Inc is paying the broker-bank an insurance fee
. In exchange, the broker-bank takes on the risk that
copper prices may fall.
Rob Kirby explains how derivatives are used to control markets: Amaranth Kill Shot: Collateral Damage in a 78 Trillion Dollar Derivatives Book Compliments of J.P. Morgan Chase (2011).
One complicating derivatives factor is that a contract may be based on a future price, or a future price difference or interest rate or interest rate difference (a 'spread') or a combination of factors....
It is also possible for derivative contracts to be linked to each other. For example, instead of specifying the price of copper, the contract may specify the price or outcome of another contract. This 'domino-chain' of inter-dependent derivatives is highly problematic as it can unravel like an endless ball of yarn.
When one bet is linked to another bet as the collateral and this continues, the effect of a payout may require a losing party to liquidate other assets or derivatives or to default. When millions or billions of dollars in derivatives are liquidated or defaulted on, a contract-tangle ensues as one liquidation triggers another and another.
There's another complication. US Treasury Bonds (an IOU) may be used as collateral in large derivative contracts. This means that a debt instrument (an IOU) is the collateral for a contractual bet. There is no backstop (item of physical value) used as a guarantee that any party involved is able to pay their financial obligations.
In trader-speak a 'derivative short position' means they bet the value of the asset or commodity is falling.
A 'derivative long position' means they bet the value of the asset or commodity is rising.
...Based on Bank of International Settlements statistics, the largest percentage of total derivatives contracts
worldwide is interest rate derivatives. These 'investments' really just bets on potential interest rate changes alone
total $505 trillion, a sum more than 25 times the size of the equally unfathomable $18 trillion United States national
debt. Yet they are not even the total of all derivatives. As Snyder rightly notes, When this derivatives bubble finally
bursts, there won't be enough money in the entire world to bail everyone out
www.AmericanFreepress.net, The Derivatives Disaster, Ronald L. Ray, June 2015
For details on how a similar large scale financial transaction called the 'reverse repurchase agreement' or 'reverse repo' is used to either inject or remove fiat money into the global economic system see the following article by Investment Research Dynamics www.investmentResearchDynamics.com, Is The Global Financial System On The Brink Of Collapse?, April 2015
What is a 'reverse repo'? Here is the over-simplified definition: it is a short-term overnight loan, usually in the millions and billions of dollars, in the form of US Treasury bonds.
...the massive operation [reverse repo] was conducted to INJECT Treasury collateral into the global banking system.
Treasuries are used as collateral against derivatives positions....
When an entity (typically a bank or hedge fund) takes on a derivatives bet, it needs to post collateral to
protect the counterparty from a decline in the value of the bet....
When the value of the derivatives bet declines because the value of the underlying asset
declines (think: Greek debt, oil debt), more collateral has to posted. Eventually, the market runs
out of collateral and there's a collateral short squeeze. The use of hypothecation
[loaning the same item to multiple buyers at the same time] exacerbates the
situation by several multiples.... Big spikes up in settlement fails occur.
www.investmentResearchDynamics.com, Is The Global Financial System On The Brink Of Collapse?, April 2015