Hi! Welcome to part three of four of my story with Three Little Securities. This one is called How Option and Bond Became the Center of an Economic Storm. Here we go.
In the next town, Option took Bond under his wing, and explained how he structured the market in his town. After he took the mortgages from that investment banker and took off. A word that the banker’s said, “Stock with me.” said Option, risk.
I talked with the banker and our brother Stock some more, and figured at our way for people to make money if they guess that the price of a stock would go up or down and we’re right. “And the banker gave me a great idea to add leverage.”
Bond looked confused, “Leverage, what’s that?” Option then took Bond to find the main exchange in the middle of town to watch a few trend options. “Bill beat but the right to call Liza’s stockholder and buy her stock at a particular price in the future.” They agreed upon the price and a deadline for Bill to call Liza put those terms into an options contract and Bill gave Liza cash in exchange for the contract.
“Bill assumed that the price of Liza’s stock would go up before the contract expired. So he locked in a low price in the contract that he wanted and they waited. Liza, who sold the contract didn’t feel the price of her stock would go above the agreed upon price plus she wanted the cash from Bill while she continue to own her stock. If Bill called her before the contract expired Lixa would have to sell Bill her stock and she would have to sell it to Bill even if the stock price in the open market rose above the price in her contract with Bill. Although she could have sold it in the open market for money she has to honor that contract with Bill.”
Option explained that’s a call option. Option continued, “And since she owned the stock when she sold this contract to Bill. She earned additional cash by using a covered call strategy, so she sold Bill the right to buy her stock at some point in the future. She got some cash and Bill locked in hopefully a lower price to buy her stock at. Well, Liza covered herself by already owning the stock if Bill called to buy the stock from her that’s why it’s called the covered call option.”
Bond was impressed with how clever his brother Option appeared to be, but Bond was still confused, “Where is the leverage?” Bond asked. Option explained, “Leverage means, you control a lot with a little bit of your resources. Kind of like how I can’t possibly pick your big butt up with my own string, but again, if I put you on a seesaw or on a lever.”
We can look at leverage in the few ways for example, buying an Options contract is cheaper than buying the asset itself like the stock, but you still control what happens with all that stock with your small investment. Also, what if Bill that next have the money to buy Liza’s stock. He could borrow it by the stock and sell it and have a profit in the open market, so once again, for small investment he can make a great deal of money.
Impressed with how clever is brother Option was in setting up his market. Bond explained the story of the fiasco that happened in his market. Option didn’t have a solution in his current book of contract types, so he boned his investment banker friend to ask his ideas.
When a person is injured in an accident ideally that person will had disability insurance to cover lost wages. If Option thought, “If only the holders of worthless mortgages back securities have a way to get some money back.” Option pondered.
So together with the banker they created a way. They didn’t call it insurance otherwise it have to abide by turf regulation and over side. Option explained to Bond, “You know what happens when you buy insurance? You go to a place that sells insurance. Get the contract, pay the regular premium then you get the money if something happens, right?” “Well, it’s kind of the same thing I’m proposing. Your seller wants to buy this protection for their bond. They go to an investment bank or in an insurance company financial arm of an insurance company. They get this contract. They pay to look premium and then receive the lump sum benefit if their bond default or becomes worthless.
Option leaned in. “When you own one of these the risk of owning the bond gets transferred or swapped to the company that you got this contract from because they got to pay you a lump some when the bond defaults, and when a bond defaults someone’s credit rating her quality must have gone to tubes which may have lead them to defaulting on the loan or bond. I hope you’re following me.
Bond shrugged I guess. Option replied. “Because I just explained what a credit defaults swap is. That’s what it is.” Bond shrugged again, “It’s sounding complicated.” But he figured Option and the investment banker knew what they’re doing.
So they begin selling these credit defaults swaps to the bond holders who were excited by this new form of protection. They solved like gang busters around the world. So one day, Bond and Option were sitting in their 30 mansion eating pork rice when they heard the knock at the door. “Who is it?” yield Option. “Little security, little security let me in.” replied the voice. Option jumped from his chair nearly passing out from a pork rice stocked in his windpipe. He cleared his throat and look to the people. “Oh, no it was inflation.”
Option panicked if bonds were paid backed folks want the cash in on their credit default swaps and get their lump sums, but Options didn’t saved money to pay theses people back. He didn’t think that many people with default on their mortgage loans.
So the problem though was that if enough people cash in on their credit default swaps that can potentially bring down the banks and insurance companies that created those credit default swaps under the sure way if having to pay all those people back.
Option said, “I never imagine this can happened.” He looked at Bond does inflation found on the door. “What do we do?” Bond reached in his suitcase, “I bought this turf maybe this can help.” Option likes forget that. It supposed to help, but it doesn’t’ help at all, and got so many holes in it forget it.
So, Bond shrugged, Option took Bond by the arm and they run to the next town to stay with their brother Stock.
So that was part three of four. I hope to see you next time for the final chapter of Three Little Securities.
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