TCS Daily


Derivative Thinking

By Dominic Basulto - October 5, 2005 12:00 AM

It seems that the more financial derivatives appear in the news, the more likely it is that regulators will attempt to regulate them. According to the conventional wisdom, investing in these derivatives is akin to throwing gasoline on a roaring fire -- homeowners could get burned if they attempt to hedge away risk in an overheated housing market using derivatives that protect against falling property prices or Wall Street traders could exacerbate an already dicey situation in the world energy markets if they make some wrong directional bets with commodities derivatives. The latest bugbear is the credit derivative, an interesting piece of financial engineering which enables companies to slice and dice credit risk into different pieces, thereby enabling investors to alter the risk profiles of their portfolios without actually changing their portfolios. Some regulators, such as the Federal Reserve Bank of New York, now fear that too much exposure to these credit derivatives could lead some big hedge funds and institutional investors to "blow up," and that's leading to whispers of increased regulation for financial derivatives.

While regulators should be applauded for their attempts to make market participants more aware of the risks of using derivatives, these fears are overstated. As TCS Contributing Editor Arnold Kling pointed out in part six ("The Proper Attitude Toward Financial Regulation") of an earlier six-part series on financial markets, regulators and laypersons alike tend to approach the issue of risk from the wrong perspective. They do not always recognize that new-fangled financial instruments like credit derivatives, instead of creating risk, are actually a response to risk that already exists within the economic environment. Derivatives allow investors to re-allocate or transfer away diversifiable risk in ways that make financial markets more transparent, more efficient and more liquid.

Why the fear about financial derivatives, then? For one thing, the overwhelming part of the population that does not work on Wall Street has little or no understanding of what derivatives actually are. Kling called this the problem of "folk finance": the average person in America, when unaware of how something works in the financial markets, tends to revert back to "misguided intuitive beliefs." People may have a fuzzy idea about futures and options, but little or no idea about collateralized debt obligations. In response, folk finance turns to government regulators to take a more active role in financial markets to sort out all the risks.

Another reason for the fear about derivatives is that the notional value of any derivatives market is scary big (there's no other way to put it). The ISDA (International Swaps & Derivatives Association) released a new report on September 28 that calculated the size of the various derivatives markets. The notional outstanding volume of the equity derivatives market is $4.83 trillion; the notional amount of the credit derivatives market is now $12.43 trillion; and the notional principal outstanding volume of interest rate derivatives is $201.4 trillion. By comparison, the total market capitalization of all of the companies on the New York Stock Exchange on any given day is anywhere between $10 trillion and $15 trillion, while the size of the U.S. corporate bond market is $5 trillion. Since derivatives are simply investment contracts structured so that their value depends on the behavior of some other thing or event, it is conceptually possible to see how the size of the credit derivatives market could dwarf the size of the corporate bond market.

Complicating matters is the fact that it is also extraordinarily difficult to value most derivatives. For example, take the most recognizable derivative instrument: the lowly stock option. The classic method for valuing stock options is the Black-Scholes option pricing model -- a model loosely based on the equation for heat transfer that depends on knowledge of partial differential equations, numerical distributions, and fiendishly nuanced mathematical assumptions about the path of stock prices. That's what makes stock options so tricky to value -- and that's why Wall Street firms now import so many Ph.D.s and quantitative number jocks to help them crunch all the numbers.

Finally, financial derivatives enable firms and individuals to turbo-charge financial returns by using massive amounts of leverage. However, as any student of finance will tell you, risk is the Siamese twin of reward, and that means the opportunity for outsized returns comes at a price. When hedge funds have the opportunity to make millions of dollars at one time without putting a significant amount of their capital at risk, it is not surprising that some of them are letting greed influence the amount of risk they are willing to accept.

As can be seen from the above, the problem is not in the financial derivatives themselves, but in how firms and individuals price, manage and hedge this risk. In the case of credit derivatives, Wall Street firms and hedge funds need to develop and put in place the type of risk management systems that have enabled them to buy and sell trillions of dollars worth of other derivatives. According to the Wall Street Journal, however, hedge funds and banks are making trades in credit derivatives faster than they can handle all the necessary paperwork. At the same time, they are relying on a one-size-fits-all mathematical model of credit risk without understanding all of the inputs into the model. Common sense, not regulation, is what is required.

Since financial innovation, not financial regulation, is what enables individuals and firms to decrease their exposure to risk, it is short-sighted to think that it is possible to regulate away risk in the various derivatives markets. Derivatives seem to be pesky little creatures that always appear in all the riskiest markets. That makes sense, of course, if you believe that financial derivatives do not create risk -- they are a response to risk.

Dominic Basulto is the editor of the popular blog Corante New York, which covers technology and business in New York. He writes about business, technology, and the financial markets for TCS.

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