Derivative Trading – Good or Evil ?

People talk about ‘derivatives’ as if all the evils of the world can be wrapped up in this single word.  How did we get into this mess? Derivatives.  Why are you making so much unfair and unjust money? Derivatives.  Why do brokers cheat all the time? Derivatives. Why did those brokers go to jail? Derivatives.

Despite all the negativity, the vast majority of its critiques are incapable of clearing explaining what a derivative is and how the financial markets benefit from and are being hurt by these instruments. Once they get past this enlightenment, a new picture emerges. Lets draw the picture 🙂

Remember that whenever change enters our world there is always the fear of the unknown. Derivatives have transformed the entire financial market and are akin to the discovery of America. Think I jest? Consider a market worth $516 Trillion dollars (According to Bank forInternational Settlements June 2007″) Source: http://www.bis.org/publ/qtrpdf/r_qt0712.pdf .  This  is the magnitude of the global trade in derivatives as compared to global trade in goods and services is being valued at $16 Trillion in 2007. (source: International Monetary Fund http://www.imf.org/external/pubs/ft/fandd/2007/12/dadush.htm)

In the first instance let us take the argument that derivatives have greatly benefited the financial world.

By definition, a ‘derivative,’ is any type of financial security that derives its value from some underlying security.  All future or forward contracts are derivatives. Hope I have not lost you already, I promise this will be painless. Here is the typical example I give to students.

Derivatives are generally used to share one kind of risk or transfer the risk elsewhere.

Example 1

If you want to have a Christmas dinner and need to feed a family of 500 with 200 chickens (big eaters), the chicken farm would sell you a future promise (contract) of 200 chickens to be collected on the day of your dinner. This Futures contract obligates the chicken farm to deliver a certain amount of chickens of a certain quality in December.  The chicken farmer has eliminated the future price risk, but now he has to make sure that the eggs hatch (so to speak).  Derivatives are used to reduce this risk. On the other hand, you also may have a cancellation and because you have paid for the chickens in advance you would suffer the loss. Derivatives also help to reduce this risk.

You and the chicken farmer have a few choices:

1)  If dinner is cancelled, you could sell the future contract to another chicken farmer who would be willing to buy them at a loss or gain to you (depending on the market conditions). Or in case the chickens do not hatch,the chicken farmer could “hedge” his or her risk by also reducing this exposure.

2)  You could ask a 2nd chicken farmer to give you the Option or choice (which you may or may not exercise) of selling the future contract to them for a minimum fee. And the chicken farmer could also pay a fee for the Option to buy 200 chickens from the 2nd chicken farmer, in case the chickens do not hatch.

The risks are spread in the market! Now remember that there is a down side. If brokers short sell the chicken contract and prices climb, the prices of chicken (through a short sell squeeze) would rise.

The bottom line is still that it is a shared risk that others are  willing to assume at a premium (price). Because derivatives can be tailor-made to a specific need, and can be created in any amount, they are exceptional tools for reducing risk. Central banks and the Church of England use derivative for this reason. (see: http://global.christianpost.com/news/church-of-england-defends-investments-in-hedge-funds-68685/)

However, there is a negative side to this of course!  Unlike future contracts, which are well regulated by exchange authorities, most derivatives are traded directly between buyers and sellers, what is known as ‘over the counter’ or OTB.

When no central authority  is in place the prices are not published and individual agreements could lead to very large losses or exposure due to non-regulation of creditworthiness. This is known as counterparty risk. Is this too much already? Almost there…we are just about done.

What is, however, the worst part is that derivatives are very difficult to value because they are based on underlying securities. To crown this problem, in OTB trades the values are not official and companies can overstate or understate their value. When firms are unable to value their derivative trades they are capable of locking the exchange system or freezing liquidity. Remember the $516 Trillion?

Conclusion: Derivatives are not bad. The regulation of derivatives is NEW and still needs to be improved. They form an entirely new form of risk spreads that will benefit each and every industry including educational institutions. The question is how can they benefit you? And the other question is should we (if the choice exists) prepare students now for a very complex financial future? I think we need to do just that.

Derivatives will not go away and neither will capitalism. Neither are perfect, but they are the best we have at our disposal and they both DO need fixing.

And THAT’s why derivatives will NOT come to your door in the middle of the night and suck your soul out through your eyeballs.

Happy Easter!

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