Why derivatives are bad

Custom-tailored financial derivatives are a neat example of how invention becomes the mother of necessity. They have done so because derivatives create a felt need for their own employment. Derivatives make it possible for businesses from construction to food processing to energy to shipping to make plans with greater certainty about their financing costs than they ever could before.

The creation and trading of derivatives earns something like a third of the profits of the big banks—and perhaps more, because many of the deals they make are done only for the derivatives activity they will stimulate.

Derivatives provide a plausible rationale for financial-industry mergers that otherwise would not make sense. These instruments are creations of mathematics, and within its premises mathematics yields certainty. The more certain you are, the more risks you ignore; the bigger you are, the harder you will fall.

Eberly and James H. A vehicle by which banks can swap loans with each other apparently gives everybody a win—banks can diversify their portfolios geographically and by category with the click of a mouse. But the system is easily gamed, and it sacrifices the great strength of banks as financial intermediaries—their knowledge of their borrowers, and their incentive to police the status of the loan.

The dilemma here is: High profits, even if there are big threats vs. Furthermore derivatives contracts like credit default swaps are often made for longer periods like 20 years. This adds additional fuel to the fire, meaning that this causes additional perverse incentives and further insecurities, because if an executive banker has to decide over these long period derivatives, it is more likely that he will allow more risky transactions if he can benefit from it.

To price a derivative correctly is difficult enough but these long periods worsen this problem immensely. You could argue about the terminology and the comparison, but indeed there are major dangers and perverse incentives coming from financial derivatives trading. Furthermore, another issue of financial derivatives in my point of view, relates again to financial derivatives being largely unregulated. To generate high profits with very little payment, financial derivatives, due to being unregulated, can be tremendously leveraged Allen, Carletti P.

Obviously this would be a great deal if the value would increase but also would cause tremendous losses if the value decreases. How much the actual potential benefits and losses are can be adjusted by the ratio. A further problem of leveraging is that it stresses the issue of the large notional value of the financial derivatives market. Also AIG had a significant amount of leveraged financial derivatives, which later on made things, as you would expect a lot worse Allen, Carletti P.

The example illustrated above is of course a very simplified and constructed example. By stretching he refers to leveraging and points out, that leveraging may be profitable for some time, but if markets crash like in , leverages will cause big problems, especially if linked to the incentives problem I mentioned before.

Executives who do not fear any consequences if they make bad decisions will naturally tend to take more risks by leveraging financial derivatives, which will certainly worsened the whole scenario. Are financial derivatives good or bad? Benefits and threats of using financial derivatives Essay, 6 Pages, Grade: 2,7. S T Sinan Tunbek Author. Add to cart. Essay Are Financial Derivatives good or bad? Sign in to write a comment. Read the ebook.

The current financial crisis in the U Acting under the "Guise of the G Evaluation of the Benefits of using R Eine kritische Betrachtung des Fair-V Financial Engineering. Was ist Web 2. Financial regulations implemented since the financial crisis are designed to tamp down on the risk of derivatives in the financial system; however, derivatives are still widely used today and are one of the most common securities traded in the financial marketplace.

Even Buffett still utilizes them and by doing so has earned a significant amount of wealth for himself and Berkshire Hathaway's shareholders. Business Insider. Berkshire Hathaway Inc. Berkshire Hathaway. Warren Buffett. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page. These choices will be signaled globally to our partners and will not affect browsing data.

We and our partners process data to: Actively scan device characteristics for identification. I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Popular Courses. Business Leaders Warren Buffett. What Is a Derivatives Time Bomb? Key Takeaways "Derivatives time bomb" refers to a possible market deterioration if there is a sudden unwinding of derivatives positions. The term is credited to legendary investor Warren Buffett who believes that derivatives are "financial weapons of mass destruction.

Common derivatives include futures contracts and options. Derivatives can be used to hedge price risk as well as for speculative trading to make profits. The financial crisis was primarily caused by derivatives in the mortgage market. The issues with derivatives arise when investors hold too many, being overleveraged, and are not able to meet margin calls if the value of the derivative moves against them. Article Sources. Investopedia requires writers to use primary sources to support their work.