But others, including Federal Reserve Chairman Alan Greenspan, say the risk of such a meltdown is
negligible. Proponents stress that the market’s hazards are more than outweighed by the benefits derivatives
provide in helping banks, corporations, and investors manage their risks.
Because the science of derivatives is relatively new, there’s no easy way to gauge the ultimate impact these
instruments will have. There are now more than 1,200 different kinds of derivatives on the market, most of
which require a computer program to figure out. Surveying this complex subject, dozens of derivatives experts
offered these insights:
Q: What is the broadest definition of derivatives?
A: Derivatives are financial arrangements between two parties whose payments are based on, or “derived”
from, the performance of some agreed-upon benchmark. Derivatives can be issued based on currencies, commodities, government or corporate debt, home mortgages, stocks, interest rates, or any combination of these. Company stock options, for instance, allow employees and executives to profit from changes in a company’s stock price without actually owning shares. Without knowing it, homeowners frequently use a type of privately traded “forward” contract when they apply for a mortgage and lock in a borrowing rate for their house closing, typically for as many as 60 days in the future.
Q: What are the most common forms of derivatives?
A: Derivatives come in two basic categories option-type contracts and forward-type contracts.
These may be exchange-listed, such as futures and stock options, or they may be privately traded.
Options give buyers the right, but not the obligation, to buy or sell an asset at a preset price over a specific
period. The option’s price is usually a small percentage of the underlying asset’s value.
Forward-type contracts, which include forwards, futures, and swaps, commit the buyer and the seller to
trade a given asset at a set price on a future date. These are “price-fixing” agreements that saddle the buyer with the same price risks as actually owning the asset. But normally, no money changes hands until the delivery date, when the contract is often settled in cash rather than by exchanging the asset.
Q: In business, what are they used for?
A: While derivatives can be powerful speculative instruments, businesses most often use them to hedge.
For instance, companies often use forwards and exchange-listed futures to protect against fluctuations
in currency or commodity prices, thereby helping to manage import and raw-materials costs. Options can
serve a similar purpose; interest-rate options such as caps and floors help companies control financing costs
in much the same way that caps on adjustable-rate mortgages do for homeowners.
Q: Why are derivatives potentially dangerous?
A: Because these contracts expose the two parties to market moves with little or no money actually changing
hands, they involve leverage. And that leverage may be vastly increased by the terms of a particular contract. In the derivatives that hurt P&G, for instance, a given move in U.S. or German interest rates was multiplied 10 times or more.
When things go well, that leverage provides a big return, compared with the amount of capital at risk. But it also causes equally big losses when markets move the wrong way. Even companies that use derivatives to hedge, rather than speculate, may be at risk, since their operation would rarely produce perfectly offsetting
gains.
Q: If they are so dangerous, why are so many businesses using derivatives?
A: They are among the cheapest and most readily available means at companies’ disposal to buffer themselves against shocks in currency values, commodity prices, and interest rates. Donald Nicoliasen, a Price Waterhouse expert on derivatives, says derivatives “are a new tool in everybody’s bag to better manage business returns and risks.”
SOURCE: Lee Berton, “Understanding the Complex World of Derivatives,” The Wall Street Journal
