Financial Regulation: The Dilemma of Derivatives Authored by Jérémy Aflalo
*Story Highlights*
Regulators face the dilemma of derivatives
The fear of dangerous, out-of-control, speculative derivatives
The need for derivatives as a risk management tool
Since the beginning of the financial crisis, a lot has been said about ―dangerous, out-of-control, speculative‖ derivative instruments, and not without justification. For instance, one of the main reasons AIG, the giant American insurer, has been bailed out by the American government is because its use of credit default swaps (CDSs), a type of derivative that insures lenders against borrowers‘ going bust, led it to guarantee at least $400 billion-worth of other companies‘ loans— including those of Lehman Brothers! So let‘s try to understand what these instruments really are, why regulators are so interested in them and what the dilemmas they face are. Derivatives come in many shapes. To sum up, the first class is comprised of futures and forward contracts, which are agreements to trade an asset at a set price at a given date in the future. The second class is options which are the right, but not the obligation, to buy or sell at a given price. The third one is swaps, which are instruments used to exchange one lot of obligations for another, such as variable for fixed interest payments. There are several reasons why derivatives are feared. The first reason is their potential to be leveraged. As a matter of fact, these contracts are sealed with initial payments that are a small fraction of the potential gain or loss. Let us take an example with an option whose underlying asset currently trades at £10.00. Think of an option to buy a stock next year at the price of £10.00, you will usually pay a premium for this option which is between £0.02 and £0.05. If one year from now, the stock is worth £11.00 you will exercise your option and will make a gain of £1.00 per option. Assuming you paid a premium of £0.05 your return on investment is 2000% (1/0.05) although the stock price just increased by 10%. Therefore, derivatives allow investors to earn large returns from small movements in the price of the underlying asset. The flip side of this is that the counterparty is going to lose large amounts of money. Think of the writer of the previous option who loses 20 times the premium he received when he wrote the call option. There have been several instances of these types of massive losses in derivative markets, especially during the crisis.
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