Performance Perspectives Blog

Derivatives … are they really so horrible?

by | Jun 6, 2009

You’ve probably noticed the continued complaints coming out of Washington, DC regarding derivatives and how they obviously contributed to our current market condition. I recall reading how one elected official said that he didn’t even know what a derivative was! Wow, how complex ARE they? While I might understand him saying he didn’t understand how a credit default swap worked or what some of the other esoteric derivatives were used for, to make the statement at the most general level, “derivatives,” suggests that the man is either ignorant or simply playing to the camera (or perhaps, bashing Wall Street, a popular game of late).

This morning I began reading a book on stochastic calculus (don’t be too impressed … I am reading the book ’cause I really don’t understand the subject at all and need to; it’s not for pleasure) and came across some comments regarding risk. One should realize that in many (if not most cases), derivatives are used to offset risk; granted, they can be used for speculation and other purposes, but risk control is often a chief reason for their development and use. This would seem to be a good idea, yes?

“A principal function of a nation’s financial institutions is to act as a risk-reducing intermediary among customers engaged in production. For example, the insurance industry pools premiums of many customers and must pay off only the few who actually incur losses. But risk arises in situations for which pooled-premium insurance is unavailable.” (Shreve, Steven E. Stochastic Calculus for Finance I. 2000) Okay, and so what do we do in these cases?

Take, for example, a hedge against higher fuel costs. Airlines, for example, would want a security whose value would rise when oil prices rise. But who would want to sell such a security? “The role of financial institutions is to design such a security, determine a ‘fair’ price for it, and sell it to airlines.” (Shreve, 2000)

Let us not become fearful of things we don’t understand.

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