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Best case, what is the societal function of derivatives? As a relatively ignorant layperson, my guess is that derivatives allow productive businesses to hedge

by tkiley 13y ago

Best case, what is the societal function of derivatives? As a relatively ignorant layperson, my guess is that derivatives allow productive businesses to hedge against uncontrollable risks. A business with less risks requires less capital buffer, which encourages & allows for more capital investment and profit-taking. In a nutshell, derivatives allow businesses to run and grow on less capital, by reducing the amount of capital-on-hand required to buffer against risk. Is there some other way in which derivatives serve an ostensibly positive function in society? Am I missing something here?

ItendToDisagree 13y ago
As the above commenter stated. In the classical example (and a perfect world) derivatives can act as a sort of "insurance" or guidebook of risk. But we do not live in a perfect world. Greed is a real thing (and maybe one of the reasons Capitalism works so damn well), so it rarely works exactly that way. In the end it is often just a way to treat the little guy as a sucker while insulating the bigger fish. Or at least that is how history has shown it to play out so far.
- WalterBright 13y ago
  When I was young, I got into a poker game with some local hoods, and they cleaned me out. I knew enough about the odds to know they were cheating, but not enough to know how they were doing it. I resolved not to play poker again until I understood the game much better. Ditto for derivatives. If you don't understand the game, you should invest in something else.
  - judk 13y ago
    My poker experience is actually closely analogous to the reality of AIG meltdown: when I lost, my buddies collected, but when I won, "we were just playing for fun, not real money".
cperciva 13y ago
Is there some other way in which derivatives serve an ostensibly positive function in society? I think the largest benefit is for organizations like pension funds which are required to minimize risk. Being able to hedge against specific types of risk (e.g., via a "longevity swap") allows pension funds to allocate their limited "risk budget" in ways which yield higher returns (thereby allowing them to pay out higher pension values).
- ItendToDisagree 13y ago
  This is a good point and can be true. As long as the market isn't manipulated this sort of thing can happen. Or even if the manipulation is minimal and there isn't a crash caused by hidden information.
vladimirralev 13y ago
Don't you just transfer the risk to some other party this way? So that other party will now have to either have the bigger buffer or transfer it to someone else. At the end there will be no net effect on the larger scale. The cycle probably continues until somebody stupid enough to dismiss the risk buys into it at loss.
- mseebach 13y ago
  It's risk, not a certain loss. And you don't "transfer" it, you sell it to a party that wants higher risk (for a fee). Derivatives are nice, in that sometimes its possible to separate the risk out from the asset. Consider a $50k loan at 5% with a 1% risk of default. A pension fund and a hedge fund both have capital, but the pension fund have extremely conservative investors and the hedge fund have extremely risk hungry investors. That loan is not a good investment for either. So a derivative is created: the hedge fund agrees to make the pension fund good if the loan-taker defaults for a one-time fee of $550 (the cash-value of the 1% risk + a $50 fee). The pension fund now has a $49,450 loan (actually, it will be booked as a $50k load both paying a bit less that 5% interest - the exact amount depends on the running time of the loan) and a $0 risk budget and the hedge fund just made $50 + a 99% chance of $500 more. All are happy, including the loan-taker who might have struggled to get someone to load him money. (Numbers pulled from thin air for illustrative purposes and lots of details omitted)
  - vladimirralev 13y ago
    That seems accurate, but it doesn't seem to account for the risk of the hedge fund going bust. It's a high risk fund so they either have the cash buffer we talked about or they transfer the risk to others. So the net effect is still null. The pension fund will be in much better position to take the 1% risk multiple times at sufficiently disconnected opportunities insuring each-other reducing the overall risk.
    - mseebach 13y ago
      No, the risk costs $500 and the hedge fund has that. They can't book the $500 before the loan has been repaid in full. The problem is what happens if the default risk (1%) turns out to be 2% instead. See: The subprime crisis.
Tycho 13y ago
I'd say in general they allow different types of risk to be stripped out from investments and passed on to people who specifically want to take them. That makes it easier for businesses (and individuals) to make plans. For instance a company could invest in a foreign market but hedge out the FX risk. They could even find a company in the foreign market who operates in their country and do a currency swap, meaning both parties get rid of unwanted risk.
lmm 13y ago
It's more general than that. You can buy and sell stock risks like any other commodity. An investor who's confident in a company, or who knows they're investing for the long term, can take on more risk, and get a higher rate of return (on average). A pension fund that's coming up to redemption time can stabilize its value, accepting a lower growth rate in return for reduced risk. It's not just the businesses themselves, it's anyone for whom the stock price matters.

by tkiley 13y ago

ItendToDisagree 13y ago

As the above commenter stated. In the classical example (and a perfect world) derivatives can act as a sort of "insurance" or guidebook of risk. But we do not live in a perfect world. Greed is a real thing (and maybe one of the reasons Capitalism works so damn well), so it rarely works exactly that way. In the end it is often just a way to treat the little guy as a sucker while insulating the bigger fish. Or at least that is how history has shown it to play out so far.

WalterBright 13y ago
When I was young, I got into a poker game with some local hoods, and they cleaned me out. I knew enough about the odds to know they were cheating, but not enough to know how they were doing it. I resolved not to play poker again until I understood the game much better. Ditto for derivatives. If you don't understand the game, you should invest in something else.
- judk 13y ago
  My poker experience is actually closely analogous to the reality of AIG meltdown: when I lost, my buddies collected, but when I won, "we were just playing for fun, not real money".

cperciva 13y ago

Is there some other way in which derivatives serve an ostensibly positive function in society? I think the largest benefit is for organizations like pension funds which are required to minimize risk. Being able to hedge against specific types of risk (e.g., via a "longevity swap") allows pension funds to allocate their limited "risk budget" in ways which yield higher returns (thereby allowing them to pay out higher pension values).

ItendToDisagree 13y ago
This is a good point and can be true. As long as the market isn't manipulated this sort of thing can happen. Or even if the manipulation is minimal and there isn't a crash caused by hidden information.

vladimirralev 13y ago

Don't you just transfer the risk to some other party this way? So that other party will now have to either have the bigger buffer or transfer it to someone else. At the end there will be no net effect on the larger scale. The cycle probably continues until somebody stupid enough to dismiss the risk buys into it at loss.

mseebach 13y ago
It's risk, not a certain loss. And you don't "transfer" it, you sell it to a party that wants higher risk (for a fee). Derivatives are nice, in that sometimes its possible to separate the risk out from the asset. Consider a $50k loan at 5% with a 1% risk of default. A pension fund and a hedge fund both have capital, but the pension fund have extremely conservative investors and the hedge fund have extremely risk hungry investors. That loan is not a good investment for either. So a derivative is created: the hedge fund agrees to make the pension fund good if the loan-taker defaults for a one-time fee of $550 (the cash-value of the 1% risk + a $50 fee). The pension fund now has a $49,450 loan (actually, it will be booked as a $50k load both paying a bit less that 5% interest - the exact amount depends on the running time of the loan) and a $0 risk budget and the hedge fund just made $50 + a 99% chance of $500 more. All are happy, including the loan-taker who might have struggled to get someone to load him money. (Numbers pulled from thin air for illustrative purposes and lots of details omitted)
- vladimirralev 13y ago
  That seems accurate, but it doesn't seem to account for the risk of the hedge fund going bust. It's a high risk fund so they either have the cash buffer we talked about or they transfer the risk to others. So the net effect is still null. The pension fund will be in much better position to take the 1% risk multiple times at sufficiently disconnected opportunities insuring each-other reducing the overall risk.
  - mseebach 13y ago
    No, the risk costs $500 and the hedge fund has that. They can't book the $500 before the loan has been repaid in full. The problem is what happens if the default risk (1%) turns out to be 2% instead. See: The subprime crisis.

Tycho 13y ago

I'd say in general they allow different types of risk to be stripped out from investments and passed on to people who specifically want to take them. That makes it easier for businesses (and individuals) to make plans. For instance a company could invest in a foreign market but hedge out the FX risk. They could even find a company in the foreign market who operates in their country and do a currency swap, meaning both parties get rid of unwanted risk.

lmm 13y ago

It's more general than that. You can buy and sell stock risks like any other commodity. An investor who's confident in a company, or who knows they're investing for the long term, can take on more risk, and get a higher rate of return (on average). A pension fund that's coming up to redemption time can stabilize its value, accepting a lower growth rate in return for reduced risk. It's not just the businesses themselves, it's anyone for whom the stock price matters.