Financial Derivatives: Risk, Speculation, and the 2008 Crisis

Introduction to Financial Derivatives

Risk is a feature associated with all productive activity. As a result, financial markets must adjust to fluctuations in exchange and interest rates. In hedging risk, corporations rely on risk management tools known as derivatives. Derivatives are defined as financial tools that provide investors with effective solutions for avoiding risk caused by market volatility (Dodd, 2006). Financial derivatives are also considered an effective risk management instrument associated with financial engineering, creating solutions to financial problems (Marks, 2010). In this paper, derivatives are examined as financial tools used to hedge against risk and speculate on future market conditions, while also demonstrating why Warren Buffett famously called them "financial weapons of mass destruction." Congress has been compelled to regulate derivatives in response to demands for transparency regarding the underlying risks to investors, in order to prevent a relapse like the one that occurred in 2008 (G. Corsetti, 2004).

Financial firms use derivatives both to speculate in trading and to hedge against unwanted market risk (D. Krawiec, 1997). Investment firms typically use speculative trading to anticipate market conditions, allowing two firms to exchange interest rates — a process that entails "swapping only the interest-related cash flows between two parties in the same currency." An interest rate swap is a financial instrument that serves the purpose of "altering the interest rate exposure of a firm's debt." These bilateral contracts, typically between corporate bond issuers, borrowers, and dealer banks, involve the exchange of two types of interest rates. The first is a fixed rate liability, which consists of coupon bonds — usually at around 5%. The second is a floating or variable rate, where market conditions are reflected in the interest rate.

As an example: an investment bank and Apple enter an agreement in which Apple has "synthetically" created a floating rate liability. The swaps are priced so as to equate the fixed rate payments with the expected floating rate payments:

PV Floating cash flows = PV Fixed cash flows

History of Financial Derivatives

Financial derivatives are not a new concept — they have existed for many centuries. The first known example can be found in Aristotle's writings, which recount the story of Thales, a poor philosopher from Miletus who developed a "financial device involving a principle of universal application" (Dennett, Searle, 2010). Thales argued that his lack of wealth was evidence that philosophy had no practical value, and he set out to prove his wisdom and intellect by demonstrating that he understood how to apply it.

Thales forecast that the olive harvest the following autumn would be plentiful. Confident in his prediction, he entered into agreements with local olive-press owners, depositing money with them to secure the right to use their presses when the harvest arrived. Because the harvest was still in the future and no one knew whether it would be abundant or poor, the press owners were willing to negotiate low prices in order to hedge against the possibility of a poor yield. When harvest season arrived and the crop proved bountiful, Thales exercised his option and sold access to the presses at a significant profit. This episode illustrates the fundamental logic underlying options contracts: the management of future uncertainty through advance agreements.

Most financial derivatives traded today are of the "plain vanilla" variety — the simplest form of financial instrument. However, variants on these basic structures have given rise to more sophisticated and complex derivatives that are far more difficult to measure, manage, and understand. For those instruments, the measurement and control of risks can be considerably more complicated, creating a greater possibility of unforeseen losses (T. F. Siems, 1997).

Wall Street's quantitative specialists continue to develop new, complex derivative products. Nevertheless, these products rest on a foundation of four basic derivative types (Matthew, Leising, 2000). Most recent innovations are designed to hedge complex risks and reduce future uncertainties. However, they require a firm understanding of the trade-off between risk and reward. Derivatives users should therefore establish a guiding set of principles to provide a framework for effectively managing and controlling derivative activities — principles that address the role of senior management, valuation, market and credit risk management, enforceability, operating systems and controls, and accounting and disclosure of risk-management positions (Thomas F. Siems, 1997).