Derivatives: Facts and Fallacies

Subject: Derivatives: Facts and Fallacies Fri Oct 22, 2010 12:03 am

To worry or not to worry

Derivatives scare many people. They don’t know what they are, or they may be quite unfamiliar with them. They don’t know how they work, and it’s not easy to learn. The amounts tossed around are fantastically huge. Most are traded behind the scenes. They are purchased in margin accounts, and this worries the untutored. Mysterious bankers, corporations, and dealers handle them mostly. Then there are the unnamed speculators and hedge funds. People worry about the financial system melting down. They worry about chains of bankruptcies. Sometimes there are big failures like Enron or Barings Bank or Orange County. People get scared. Regulation seems lax. Accounting for derivatives is tough and highly technical. Deciphering derivatives in footnotes of annual reports is unpleasant. People worry and worry, and there seem to be many reasons to worry. When they’re not worrying, they’re predicting disaster.

The worry is greatly overdone. Derivatives are worth some thought for investors, but they’re a side show. They’re the tail, not the dog. The tail won’t wag the dog. They’re worth some concern, but not too much. There are more important issues to worry about. (See Callahan and Kaza for another readable and useful introduction and defense of derivatives.) The degradation of responsible accounting because of government interference is a bigger concern. The Fed’s too big to fail policy is a bigger concern. The root causes of bear markets are a bigger concern.

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