The Value of Derivatives

April 10th, 2009

As I proved in an earlier article, Does Dark Matter Matter?, I don’t know much about quarks and hadrons in particle physics.  I know even less about derivatives and credit default swaps in high finance.  From everything I’ve heard, the financial crisis began with subprime mortgage defaults, transmogrified into derivatives and maybe credit default swaps, and ate my mutual funds.

The only thing I can draw comfort from is that no one else seems to know more than I do, or at least not much more.  That especially applies to members of Congress.

Now comes another wizard, Rene M. Stulz, who claims that it’s not the fault of derivatives that we’re in such a financial mess.  In fact, according him, derivatives are useful little suckers that we shouldn’t be badmouthing.

Before we get into his defense of derivatives, here’s a not-very-useful definition:

Derivatives are financial products, such as futures contracts, options, and mortgage-backed securities. Most of derivatives’ value is based on the value of an underlying security, commodity, or other financial instrument.

In Defense of Derivatives and How to Regulate Them in The Wall Street Journal Opinion Journal, Dr. Stulz says:

…if you read the headlines these days, you might think derivatives were made from arsenic by Wall Street institutions bent on causing financial destruction.

There are two sides to derivatives—one positive and beneficial, one exploitative and negative. Of the latter, the most visible example today comes to us courtesy of the American International Group (AIG) and reveals what happens when a lightly regulated but highly interconnected financial institution ends up positioned in a way that it cannot survive a housing crash and then such a crash occurs.

The other side of derivatives, however, involves the less-publicized but widespread use of these financial instruments in ways that benefit companies. Derivatives have been immensely valuable tools and will be instrumental in providing the liquidity needed to jump-start the economy. Derivatives are used by a vast number of U.S. companies, both small and large, to manage various risks that arise in connection with their businesses. …

The subprime mess triggered one of the most destructive financial crises in decades. It’s not surprising, then, that the hunt is on for culprits. But derivatives are not the culprit. They had little to do with the rise and collapse of housing prices. Wider availability of housing derivatives would have actually reduced the impact of the collapse of housing prices if homeowners had been able to hedge against possible decreases in home values.

Our businesses need derivatives. Most of us choose to drive cars even though they sometimes crash. But we also insist that cars are made as safe as it makes economic sense for them to be, and that speed limits and other rules of the road are enforced. The same logic should apply to derivatives.

I still don’t know what he’s talking about.  Maybe we should shoot a few dozen derivatives through the Large Hadron Collider (Does Dark Matter Matter?) and see what comes out the other end.  Probably regurgitated chunks of my mutual funds.

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5 Responses to “The Value of Derivatives”

  1. Kevin |

    LOL – I think you might be onto something here, Tom! Exotic derivatives, exotic matter, it’s all exotic to me. Crank ’em up to lightspeed and let ‘er rip! Sort of a high-tech version of the old destruction derbies.

  2. Brian |

    I’m with you guys, but I have a bit more cynical view of it. I still think it’s just obfuscation. The real issue I see is our financial system (meaning the Federal Reserve system), and many of the silly rules congress imposed on the financial industry. If three men with our education and breadth of experience cannot wrap their heads around this, what hope do people of different interests have? And cynically, I believe that this is the point – to make people believe that this is something beyond their kin. I don’t buy it for a second.

  3. Tom |

    I don’t know whether the opaque workings of the financial system is intentional or not, but it has the same effect. Frankly, I sometimes think it’s just as logical to take your money to Las Vegas as it is to invest in the stock market. At least you can understand the rules of the game, and you have a small chance of winning if you’re smart and careful. Well, maybe not, but lately it sure seems that way.

  4. Kevin |

    Frankly, Tom, I think you’ve touched on a major source of our recent troubles. A major problem with underregulated (or not regulated at all) derivatives is that they’re created by insiders specifically to tilt the odds in their favor. Occam’s Razor leaves precious few alternate explanations for the incentive to create derivatives in the first place.

    Regulation is to the markets what cops are to society. Both exist to insure that the game isn’t rigged, to insure that the American dream is in fact open to everyone equally.

  5. doris |

    You mean me, Brian. Hey, my coffee can buried in the back yard doesn’t sound so stupid now. I lost not a penny in the crisis, just the cost I have to pay for goods. Wish I still had my Exxon stock, though, it isn’t hurting much. I hear gun and ammo stocks are steadily going up, too. They can’t keep up with ammo demands. I think everyone is considering suicide.

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