The Economist reports on Derivatives

It just so happens that The Economist included a briefing on the derivatives market in this weeks print edition at the same time which my financial planning curriculum is covering the subject.

In studying these instruments for financial planning purposes I know first hand that these tools are difficult for most people to wrap their heads around.  However, they are incredibly important to the functioning of our economy.  How are they useful?

In the mortgage industry derivatives make it possible for consumers to “lock” an interest rate.  When we lock a rate for a customer we notify the lender that we would like them to reserve an amount of money for a specified number of days at a specific interest rate.  This allows the consumer to rest well at night knowing that they will be able to afford their mortgage payment.  However, the only reason this is even available to consumers is because lenders use derivatives to hedge interest rate changes from the time of lock to the time of funding.

But lets be honest, derivatives can also be the cause of great peril.  Much of the expansion of credit which ultimately led to the credit crisis was made possible because of derivative contracts.  As a result regulators are now looking at the derivatives market and some analysts are even calling for severe limitations to be placed on the derivatives market.

The Economist article does a good job of explaining how the availability of derivatives helps the economy but also concedes better oversight is needed.  Here are some notes from the article:

*What are derivatives? “Futures are agreements to trade something at a set price at a given date.”

*What are some examples? “Derivatives come in many shapes. Besides futures, there are options (the right, but not the obligation, to buy or sell at a given price), forwards (cousins of futures, not traded on exchanges) and swaps (exchanging one lot of obligations for another, such as variable for fixed interest payments). They can be based on pretty much anything, as long as two parties are willing to trade risks and can agree on a price: commodities, currencies, shares or bonds.”

*Who uses them? “…businesses use derivatives to shift risks to other firms, chiefly banks, that are willing to bear them. An airline worried about fuel prices can limit or fix its bills. A bank concerned about its credit exposure to the airline can pass some of its default risk to other banks without selling the underlying loans. About 95% of the world’s 500 biggest companies use derivatives.”

*The article goes on to talk about how derivative contracts are exchanged.  One problem is that a majority of derivatives are sold “over-the-counter” (OTC) as opposed to over an exchange.  One problem with OTC transactions is that they are typically done with very little margin (greater leverage) and counter-parties (the two parties who engage in a derivative contract) may not be fully aware of the others risk exposure.

*The article suggests that requiring higher capital charges for entering OTC derivative contracts would be a good policy but exempting firms from participating is a bad idea.