The Swaps Market: Valuing a 700 Trillion Dollar Market

[Jim Kata]

How can the swaps market be valued at over 700 trillion dollars, yet the world's entire GDP is only 60 trillion dollars? Is there more insurance in the world than there is value in the world?

 

[John Creighto]

How can the swaps market be valued at over 700 trillion dollars, yet the world's entire GDP is only 60 trillion dollars? Is there more insurance in the world than there is value in the world?

To equate a differentail quantity (like GDP) to a state quantity like the value of some asset you need some way of putting them in common terms like present value:
http://en.wikipedia.org/wiki/Present_value

The total value of assets can exceed the net value because of leverage and cancalation effects in risk exposure. In the case of swaps if you ensure both postions your risck cancels out. Now in a perfectly efficient market a swap market a given postion should be neutral when purchased in terms of asset value but as it matures it may gain or lose value. The oppostite postion would respond in the opposite way. Assets as a whole only increase if the people who end up with a losing postion don't sell assets to maintain a constant leverage.

I will need to give some more thought to say much more.

 

[Office_Shredder]

The way an interest rate swap works is as follow:

I want to bet on the LIBOR interest rate going up from its current position. You want to bet on it going down. So we take out loans against each other for 1000 dollars - you pay, say, the LIBOR rate, and I pay 2% (or whatever the LIBOR rate currently is). This swap has a NOTIONAL value of 2000 dollars, since we each owe each other 2000 dollars. This is what's often referred to when people talk about 700 trillion dollars in derivatives. In reality, at the end of one year you're going to owe me maybe 1022 dollars and I'm going to owe you 1020 dollars, so you're going to end up just paying me 2 dollars.

 

[BWV]

FWIW, the net value of all global derivatives is zero

 

[Jim Kata]

Thank you for the answers. I am very naive to this subject so I need to add some follow up questions. The general answer I believe I'm getting is that the net value is zero since people are taking out bets against each other and they cancel out. I might be inclined to believe this if I thought this market was a closed system. However, in the crash of 2007 investment banks and insurers like AIG who lost these bets did not have the funds to cover their losses so they had to be bailed by a third party (taxpayers) who weren't directly involved in the bets. So this leads me to two more questions. How can investment banks and insurers be allowed to make bets that they can't afford to lose, and how can this market be seen as neutral if even the losers are bailed out by third parties?