Derivatives are designed to reduce risks of investors in stock markets, currency markets and commodity markets. Risk is inherent in all business activities. A ship is safe inside the harbor. However it faces risks when it moves out of its safe abode. But keeping a ship inside the harbor does not make any sense as it is made to carry goods across the seas facing contingent risks. Therefore business has to deal with the risk. Derivatives distribute business risks to others who are ready to take the risks for a return.
Derivatives were blamed for most of the financial disasters in the current times. Even informed investors like Warren Buffet termed Derivatives as “Financial weapons of mass destruction”. In fact derivatives are weapons of mass destruction in the hands of speculators who underestimate the risks they buy from others.
If the history of the financial failures in the recent past is scrutinized it will be clear that all the failures were caused due to the underestimation of risks by overconfident financial wizards. LTCM failed even though it had Nobel Prize winners in its Director Board. Barings Bank failed because the director board failed to understand the risks of giving too much power to employees without any control mechanism. Big insurance companies like AIG failed due to their underestimation of risks inherent in guaranteeing the sub-prime housing loans. Even Allen Green Span failed to estimate the implications of increasing interest rates. If he ever had an inkling of the implication of interest rate hikes on home loans he would have thought twice before increasing the interest rates. He would have reconciled to inflation as inflation in a booming economy is much better than a prolonged recession.
Author: Cyriac Kandathil
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