"It is commonly said that derivatives transfer risk. This is not technically true, but often appears to be the case. "

Derivative Dribble with an excellent explanation of synthetic instruments. Please read his blog.

Here was my question:

“So, A has taken its floating rate LIBOR bonds and effectively transformed them into fixed rate bonds. We say that A has achieved this fixed rate synthetically.”

Why would anyone do this if you could just study and buy fixed rate bonds?

The only point seems this:

“This is not the same risk that A was exposed to before the swap (any increase in LIBOR) but it is a similar one (any increase in LIBOR above 8%).”

In other words, its only real use is for hedging. Using such a device to counteract risk you have of the investment you first procure going the other way, and you pocket the difference.

Again, if my question doesn’t make sense, don’t bother with it, and I’ll continue reading the other questions.

Here's the answer:

"Hi Don,

Why would someone want to “swap out” of floating rate loans? Some institutions do well at dealing with interest rate risk. Others do not. Many companies would prefer fixed liabilities to variable ones since this makes planning easier. So, such firms would prefer to borrow at a fixed rate. The problem is that their investors might demand a floating one.

Also, I think you’ve confused the “seller” and the “buyer” of the bonds. Companies sell bonds to raise money, investors buy them. The swap in the example doesn’t affect the investors’ cash flows. They still get LIBOR.

I think that answers both of your questions. If it doesn’t, let me know."

Okay. Let me follow him:

"A derivative is a contract that derives its value by reference to “something else.” That something else can be pretty much anything that can be objectively observed and measured. For example, two parties, A and B, could get together and agree to take positions on the Dow Jones Industrial Average (DJIA). That’s an index that can be objectively observed and measured."

Okay. I'm going to call this a scale. A scale is a set of numbers that can go up or down, depending where you are on it.

"The parties can agree to distribute gain and loss in the underlying reference (the DJIA) any way they like: that’s the beauty of enforceable contracts.'

We agree to pay each other on how the items on the index move, or where the number is on our scale. Okay. We made up the rules.

"This is accomplished without either of them taking actual ownership of any stocks in the DJIA. We say that A is synthetically shorting the DJIA and B is synthetically long on the DJIA. This type of agreement is called a total return swap (TRS)."

Okay. We're dealing with the index or scale, not the items in the index or whatever causes the scale to move. We don't care what causes the scale to move, except to the extent that we feel we can predict it, of course. If I am short ( the index or scale goes up beyond a certain point ), I lose money. If I am long ( the index or scale stays below a certain point ) , I lose money.

I guess you can call it total return since it covers an entire index or scale, and a synthesis in that it joins two options that together cover an entire index or scale.

Now it gets tricky. I'm the guy who is short. I buy actual stock or items. If the index goes up, I have the items, if it goes down I get paid by the long guy. I'm canceled out, but make a fee for doing this for the long guy I suppose.

Now the long guy still owns nothing. Since the long guy could just buy the stocks, or borrow the money to buy the stocks, this deal must give him the same exposure to those stocks for less money. Hence, a higher return on investment.

Okay, the short guy is hedged, the long guy, isn't. I think I get it. I wouldn't be competent to judge such a transaction in a million years, but I can imagine someone who could.

Then we have this:

"For example, assume that A and B enter into an interest rate swap, where A agrees to pay B a fixed annual rate of 8% and B agree to pay A a floating annual rate, say LIBOR, where each is multiplied by a notional amount of $100. Each party agrees to make quarterly payments. Assume that on the first payment date, LIBOR = 4%. It follows that A owes B $2 and B owes A $1. So, after netting, A pays B $1."

Okay. I'm fine with this. One guy, fixed interest, another guy, floating interest. Isn't there going to be a clear winner or loser here? Before, in our hedged example, I could both sides making out, although I'm incompetent to do the math. Now, it looks like a wager.

"Before A entered into the swap, A was exposed to the risk that LIBOR would increase by any amount. After the swap, A is exposed to the risk that LIBOR will fall under 8%. So, even though A makes fixed payments, it is still exposed to risk: the risk that it will pay above its market rate of financing (LIBOR)."

Maybe this is some sort of quantum logic I don't understand, but it looks to me like A has simply changed his terms. And here's my problem: Why? I don't see why there isn't a straightforward way of doing this unless it is still a hedge for A, but there seems to be a clear win or loss, so what's the hedge? In other words, why not simply have insurance? If this happens, I pay you this? That seems clean and simple.

"Essentially any risk that has an objectively observable event and an objectively measureable associated magnitude can be assigned a financial component and allocated using a derivative contract. There are derivative markets for risks tied to weather, energy products, interest rates, currency, etc."

Why? It sounds like saying that one can bet on anything that has a clearly defined winner or loser or a clearly defined score. What am I missing? Insurance, I understand. I pay you money to pay me money if something happens. I understand bonds. I loan you money, you pay me interest for a time and then give me money back. I understand betting. We pick a winner or loser based on our supposed knowledge, and one of us wins. I understand hedging, in that it seems to be a way of getting a better term on some investment for a fee to the hedger, say. But this last investment seems like a wager. I bet that the market goes one way, you bet that it goes the other. I'm sorry, but unless I'm missing something, and I'm sure that I am, that seems like betting, and not investing.

But I'm no Paul Erdos. There was a great book about him called "The Man Who Loved Only Numbers", a book on me would be called "The Man Who Couldn't Even Understand Simple Explanations".

It's not Charles fault. He's clearly explained it. I'm having a hard time figuring how I could use it. Sadly, I might never be able to understand, but then, I don't understand modal logic. It seems to necessitate that anything that can happen does. I'm okay with that, I just don't understand it.