Should We Fear Derivatives?

I n chemistry, a derivative is defined by the Merriam-Webster dictionary as a “substance related structurally to another substance and theoretically derivable from it” or “a substance that can be made from another substance.” Derivatives in finance work on the same principle. They are financial instruments whose promised payoffs are derived from the value of something else, generally called the “underlying.” The underlying is often a financial asset or rate, but it does not have to be. For instance, derivatives exist with payments based on the level of the Standard and Poor’s 500, the temperature at John F. Kennedy International Airport or the number of bankruptcies among a group of selected companies. The last 30 years have seen an astounding growth in the market for derivatives. Some estimates of the current size of the market for derivatives exceed $200 trillion, which is more than 100 times what it was 30 years ago, when most of the derivatives that comprise this market were not even available. When derivatives cause losses, they can make headlines. In recent years, derivatives have been associated with the collapse of the Queen’s banker (Barings); with a hedge fund that counted among its partners academics rewarded with a Nobel Prize for their work on pricing derivatives (Long-Term Capital Management); with the collapse of the Thai baht; and with the fall of Enron. Warren Buffett (2003) recently drew attention with a blistering attack on derivatives, writing in the 2002 annual report of Berkshire Hathaway that “derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” Do derivatives mostly threaten firms and the economy, or do they increase