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?

Well, there’s knowledge risk; that is, players do not understand the contracts they are getting into.  How can we know the prices of assets in the future, today?  Some argue that mathematics plays a role in pricing, but have you ever seen how complex the pricing formulas are?  Considering that new forms of derivative contracts are invented almost daily, the calculations only grow in complexity.

Now consider that in 2009 the Bank for International Settlements valued the notional amounts of outstanding over-the-counter derivatives at approximately $800 trillion worldwide, more than thirty times U.S. GDP.  When the market is this huge; yet lacks economic rationality, often opting for gambling on hunches, there’s reason to worry.

There’s also the accounting for derivatives.  In the U.S., mark-to-market accounting is primarily used for derivative reporting.  This means that worth of derivatives reported on balance sheets are partially based on the management’s estimates of what future prices may be. 

Ethics aside, managers whose compensation depends on earnings may be tempted overestimate the value derivatives.  In turn, this distorts true earnings but more importantly, places the company and shareholders in economic danger when these optimistic valuations fail to materialize.

Well, perhaps we can properly regulate the derivatives market?  That’s easier said than done.  How does one regulate the over-the-counter derivatives market; where there is a lack of a centralized system of exchange?  Indeed, the Obama administration has taken some steps towards increasing transparency by forcing more trades onto exchanges and through clearinghouses, which guarantee the transactions and require dealers and corporate end-users to post collateral and meet daily margin requirements.

[pullquote]The risks involved with derivatives may not be properly understood even by the most sophisticated of investors.[/pullquote]

But when prominent businessman George Soros publicly remarked that the risks involved with derivatives may not be properly understood even by the most sophisticated of investors, how can we expect to define the problem and come up with a solution?  How can we expect government officials to have the sufficient know-how to regulate these complicated markets, which are constantly evolving?

Can we maybe just let it be?  Well, according to the Office of the Comptroller of the Currency, in the United States, the “top five institutions in terms of derivatives exposure—Citigroup, J. P.  Morgan/Chase, Bank of America, Morgan Stanley and Goldman Sachs—hold over 95% of derivatives exposure of the top 25 U.S. bank holding companies.”

These same institutions have relied on the support of the public treasury during the recent financial crisis.  This means that taxpayers have a direct interest in how the derivatives markets are structured and regulated.  It’s unfortunate that the individuals most affected by the derivatives markets are those that understand it the least.  The world cannot afford another financial crisis.  But who can we turn to for the answer?

ARB Team
Arbitrage Magazine
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