Derivatives: Financial Ingenuity or Ticking Time Bomb?

A brief look into the world of derivatives, their role in risk management, and the need to increase their regulation

By Andi Kusuri, Editor-in-Chief

“Simply put, a derivative is a bet.”

There are things in today’s business world that the average person may not fully understand, but could if they took the time to make sense of it. Derivatives seem to be an exception.

In 2002, Warren Buffet called derivatives “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” Buffet’s warning proved true. Derivatives have been partly blamed for the unravelling of the U.S. economy in 2008, leading to the financial crisis which we have yet to fully recover from.

The problem with derivatives is founded in their ambiguity. It’s difficult to properly define derivatives, let alone understand them. Broadly speaking, a derivative is simply a financial instrument—typically in the form of an option, a future, a forward or a swap—that assumes its value from the price of some underlying commodity or financial asset. Confused yet?

[pullquote]Simply put, a derivative is a bet.[/pullquote]

Simply put, a derivative is a bet. They are essentially contracts involving two parties which take opposite positions on an outcome such as how an index, a price, or even the weather is going to change.

Because a business is exposed to unpredictable changes in input prices and interest rates, risk control is a priority. In theory, derivatives play an important role in risk management: they transfer risk from people who do not want to it to speculators who are willing to do so in return for the chance to make a profit.

To illustrate, consider an airline company whose profits depend on fuel prices for its airplanes. To minimize the risk associated with fluctuations in fuel prices, the airline may choose to create a contract now to pay a predetermined price for fuel in the future, regardless of the future market price.

If the price of fuel skyrockets in the future, the airline is protected because it has already agreed to purchase fuel at a lower price. However, if the price of fuel drops, the airline is hurt because they are forced to buy at a higher price than the market.

The contract is a sum-zero game, as the airline loses what the distributor gains and vice versa.

Proponents of derivatives strongly highlight their role in promoting economic growth. Using our airline example, by locking into a guaranteed price of jet fuel, the airline can then engage in projects that would otherwise be too risky. In his article “Will Derivatives kill us or make us stronger”, columnist Daniel Gross argues that “the comparatively low and steady prices we pay for staples like bread, vegetable oil, and coffee have everything to do with derivatives. ”

Why then is the derivatives market dangerous?