Financial matters

CRITICISMS OF DERIVATIVE MARKETS

Derivatives have been highly controversial for a number of reasons. For one, they are very complex. Much of the criticism has stemmed from a failure to understand derivatives. When derivatives fail to do their job, it is often the derivatives themselves, rather than the users of derivatives, that take the blame. Yet, in many cases, the critics of derivatives simply do not understand them well enough. As described in former posts, when homeowners take out mortgages, they usually receive a valuable option: the right to prepay their mortgages. When interest rates fall, homeowners often pay off their mortgages, refinancing them at lower rates. The holders of these mortgages usually sell them to other parties, which can include small organizations and individuals. Thus, we often find unsophisticated investors holding securities based on the payments from mortgages. When homeowners refinance, they capture huge interest savings. Where does this money come from? It comes from the pockets of the holders of mortgage securities. When these unsophisticated investors lose a lot of money, derivatives usually get the blame. Yet these losses went into the pockets of homeowners in the form of interest savings. Who is to blame? Probably the brokers, who sold the securities to investors who did not know what they were buying-which leads us to the next common criticism of derivatives.
The complexity of derivatives means that sometimes the parties that use them do not understand them well. As a result, they are often used improperly, leading to potentially large losses. Such an argument can, however, be used to describe fire, electricity, and chemicals. Used improperly, perhaps in the hands of a child or someone who does not know how to use them, all of these can be extremely dangerous. Yet, we know that sufficient knowledge of fire, electricity, and chemicals to use them properly is not very difficult to obtain. The same is true for derivatives; treat them with respect and healthy doses of knowledge.
Derivatives are also mistakenly characterized as a form of legalized gambling. Although gambling is certainly legal in many parts of the world, derivatives are often viewed as a government’s sanction of gambling via the financial markets. But there is an important distinction between gambling and derivatives: The benefits of derivatives extend much further across society. By providing a means of managing risk along with the other benefits discussed above, derivatives make financial markets work better. The organized gambling industry affects the participants, the owners of casinos, and perhaps some citizens who benefit from state lotteries. Organized gambling does not, however, make society function better, and it arguably incurs social costs.
We have taken a look at what derivatives are, where they come from, where they are now, why we have them, and what people think of them. Understanding derivatives, however, requires a basic understanding of the market forces that govern derivative prices. Although we shall cover derivative pricing in more detail in later posts, here we take a brief look at the process of pricing derivatives by examining some important fundamental principles.