Derivatives are contracts that transfer financial risk from one investor to another. For example, an option is a contract that gives an investor the right, but not the obligation, to buy an asset from another investor at some future date at a prearranged price.
Derivatives can be arranged on an exchange, such as the Chicago Mercantile Exchange, or can be traded “over the counter” (OTC), by a private bilateral negotiation between the counterparties. Derivatives serve several important functions. For example, they allow investors to “hedge,” that is, reduce risk. Some investors use derivatives to speculate, taking on additional risk in return for an expected profit. Although “speculation” is sometimes dismissed as a socially unproductive activity, without speculators, hedgers would often be unable to lower their risk at a reasonable price, just as without insurance companies, it would be difficult to get flood insurance. Speculators also tend to gather information about the underlying fundamentals of the asset whose risk is exchanged, causing derivative prices to reveal useful information to all investors.
Exchange trading of derivatives offers more transparency than over-the-counter trading, and less exposure to counterparty failure. OTC trading allows easier customization to the needs of investors, and fosters innovation. It is difficult to support the view that we should have only exchange-traded derivatives. With or without exchange trading, it is critical that investors should not take so much risk as to destabilize financial markets.
The ongoing financial crisis has been exacerbated by the excessive risk taking of some financial institutions that are “too big to fail,” and whose losses have led to financial instability and a severe restriction of credit to consumers and firms. Some of the excessive risk taking was through the use of derivatives. For example, AIG, the large insurance company, was brought nearly to the point of insolvency through several hundred billion dollars of positions in credit derivatives, by which AIG insured default losses on residential mortgages. AIG had to be rescued by the federal government to avoid an even deeper financial crisis than we have seen. Better oversight by firms and their regulators of levels of risk taken through derivatives and through the use of leverage (borrowing money to buy risky assets such as mortgage-backed securities) would probably have averted the most serious damage to our economy over the past year.
Because derivatives are an extremely efficient way to transfer risk from one investor to another, they require particularly careful oversight. Even though the net losses on all derivatives must be zero (because one counterparty to a derivatives trade gains whatever the other counterparty loses), when systemically important financial institutions have life-threatening losses, everyone suffers.
Darrell Duffie, PhD ’84, is the Dean Witter Distinguished Professor in Finance at the Graduate School of Business. He is the author of Dynamic Asset Pricing Theory (Princeton University Press, third edition 2001) and a co-author with Ken Singleton of Credit Risk (Princeton University Press, 2004).