managing your money

What is different about the 2008 crash?
The 2008 market crash was an accident many years in the making, just waiting to happen! In this regard, we should be neither shocked, nor surprised.

With the advent of the ever increasing power of computers throughout the 1990's until now, financial engineers have evolved and developed an increasing array of sophisticated derivative products that have leveraged, or geared, our financial system to breaking point.

For each dollar that you deposited with your bank, that bank in turn could lend many multiples of that dollar to someone else, largely via derivative products. When those leveraged and borrowed assets turned sour with the onset of the housing market bubble, someone had to be liable.

Understanding how the 2008 crash happened.

Simply put, a derivative security or product is an extension of the underlying asset for investment or speculative purposes. A simple example is the option to buy stock. This is known as a call option. A call option gives the holder the right, but not the obligation, to purchase stock at an agreed price (the strike price), on or before a pre-determined date (the expiry date). For this right, the holder (or buyer of the call option) pays the seller a price (the premium). The buyer's risk is limited to the price paid for the option, as this loss cannot be more than the premium paid. For the seller of the option however, the risk profile is very different, in fact, it can result in unlimited losses!

Consider the following example;

You have bought a call option in XYZ stock for $1.00 with a strike price on XYZ of $10.00. If the stock falls below $9.00, you would not exercise your right, and you would lose your $1.00 premium when the option expires. The seller would make $1.00 profit, his maximum profit. Now, what would happen if stock XYZ starts moving higher before the expiration date?

The smarter seller of the option would have made sure that he owned XYZ as covered stock, at the time he sold you the option, thereby ensuring his $1.00 profit. Unfortunately, in the context of the 2008 crash, this did not happen. If XYZ suddenly moved to say $20.00 before expiration, you would exercise your option and make a $9.00 profit (the difference between the current price of $20.00, less the strike price of $10.00, less the premium of $1.00). If the seller did not cover his position as the stock moved higher (against him), he would have to suffer the $9.00 loss as he is obliged to deliver the stock to you at $10.00. Or worse, he would have to borrow money to purchase the stock, to deliver to you. Starting to sound familiar?! And if XYZ moved even higher, the problem for the seller only gets worse.