The Economics of Derivatives

Derivatives...make it more likely that risks are borne by those best able to bear them. This makes it possible for individuals and companies to take on more risky projects with higher promised returns and hence create more wealth by hedging those risks that can be hedged.

Derivatives are financial instruments whose promised payoffs are not the result of ownership of the cash flows of a particular company, but rather are derived from the value of some financial asset or something else altogether. For instance, derivatives exist with payments based on the level of the S&P 500, the temperature at Kennedy Airport, or the number of bankruptcies among a group of selected companies. Derivatives have been traded for centuries, with early examples including tulip bulb options in Holland and rice futures in Japan during the 17th century. But futures markets were relatively small until the 1970s when developments in pricing methodology spurred spectacular growth. The derivatives market has grown 100-fold over the past 30 years, with estimates of the current size of the market at more than $200 trillion, based on the notional value of contracts outstanding.

According to NBER Research Associate Rene Stulz, we should not be afraid of derivatives, but rather should have a healthy respect for the benefits that they bring - at the same time being vigilant to the risk of large losses at the company level that may, in some instances, lead to systemic risks. In Should We Fear Derivatives? (NBER Working Paper No. 10574), Stulz surveys the nature, growth, and development of derivatives markets, the companies that use derivatives, and the way in which they are used.

Derivatives allow individuals and companies to hedge risks. This means that they make it more likely that risks are borne by those best able to bear them. This makes it possible for individuals and companies to take on more risky projects - with higher promised returns - and hence create more wealth by hedging those risks that can be hedged. Surveys suggest that 64 percent of US companies use derivatives. Non-financial firms are most likely to do so to hedge interest rate and currency risks. This leads to a more productive economy - and to greater economic welfare.

However, inexperienced or reckless investors and companies may get into trouble - taking on risks they are poorly equipped to quantify and understand. Since one trader's loss is another's gain, this need not typically create problems from an economy-wide perspective. But there can be problems when an individual investor's or corporation's exposure to derivatives becomes excessively large relative to the overall market. In 1998, the collapse of Long-Term Capital Management - which had capital of $4 billion, assets of $124 billion, and derivatives exposure of more than $1 trillion - was seen as a systemic risk serious enough that the Federal Reserve called in its creditors to organize a bailout.

The derivatives risks of banks and investment banks are generally well understood and managed, Stulz says, but the derivatives risks taken by insurance companies, hedge funds, and Fannie Mae and Freddie Mac -- the government-sponsored agencies -- are not equally well understood.

Derivatives also may lead to less transparency and reliability in accounting statements. There may be scope for substantial management discretion, for example, as to how to account for derivatives. Freddie Mac, the government-sponsored housing finance company, got into trouble in 2003 because it used derivatives to hide billions of dollars of profits to achieve a smoother earnings path. Derivatives that trade in liquid markets can be bought and sold at the market price - meaning that the valuation is relatively straightforward. Illiquid markets make price discovery more difficult. Surveys show that while traders may be in close agreement on the value of actively traded derivatives they may be wide apart on less liquid securities. This can lead to situations where similar derivatives are valued at very different prices in different companies. Accounting statements may be of little help in detailing how derivatives are used and in assessing the overall risk of the portfolio without an adequate accompanying explanation of the use of derivatives.

Stulz concludes that derivatives should be treated in the same way as airplanes. We do not fear flying because there is a risk of a crash, but rather we regulate the airline industry to make planes as safe as it makes economic sense for them to be. While derivatives have been blamed, sometimes wrongly, for large losses - from Barings to Enron - the benefits are widely dispersed and may not make for good headlines. On balance, the benefits outweigh the threats.

-- Andrew Balls