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The lesson from these case studies should now be obvious. Risk management is not the art of picking
good bets. Bets, no matter how good, are speculation. Speculation increases risk and subjects
corporations, investors, and even municipalities to potential losses. Derivatives are powerful tools to
shed risk, but they can also be used to take on risk. The root causes of the debacles described in these
cases are greed, speculation, and in some cases incompetence, not derivatives. But just as derivatives
facilitate risk management, they facilitate greed and speculation. Anything that can be done with
derivatives can be done more slowly the old-fashioned way with positions in traditional financial
instruments. Speculators have always managed to lose large sums. With the aid of derivatives they
now can lose larger sums faster.
Superior intellect and sophistication cannot protect the speculator. As the Long-Term Capital
Management story illustrates, when you are smarter than the market, you can go broke waiting for the
market to wise up.
Government regulation is not the answer, either. The benefits of regulation must be weighed against
the costs. Derivatives, properly used, are too important in the modern financial marketplace to be
severely restricted. Abuse by a few does not warrant constraints on all users. A better solution to
prevent repetition of the past debacles is full information disclosure by firms, portfolio managers, and
municipalities. Investors and citizens should demand to know how derivatives are being used when
their money is at stake. Better information and oversight provide the most promising approach to
prevent misuse of derivatives while retaining the benefits.
Derivatives can be dangerous, but they can also be tremendously useful. Dynamite is an appropriate
analogy. Misused, it is destructive; handled with care, it is a powerful and constructive tool.
Derivatives are tools that facilitate the transfer of risk. Interest rate derivatives enable managers to
shed business exposure to interest rate fluctuations, for example. But when one party sheds risk,
another party necessarily must take on that very exposure. And therein lies the danger of derivatives.
The same instrument that serves as a hedge to one firm might be a destabilizing speculative instrument
to another. Without a proper understanding of derivatives, a manager who intends to reduce risk might
inadvertently increase it. This chapter aims to provide the reader with a basic understanding of
derivatives so that they can be used appropriately to manage financial risks. This understanding should
help the reader avoid the common pitfalls that have proved disastrous to less informed managers.
Size of the Derivatives Market and Widespread Use
A derivative is a financial instrument whose value or contingent cash flows depend on the value of
some other underlying asset. For example, the value of a stock option depends on the value of the
underlying stock. Derivatives as a class comprise forwards, futures, options, and swaps. Numerous
hybrid instruments combining the features of these basic building blocks have also been engineered.
The first thing the interested manager must understand about derivatives is that the business in these
instruments is now huge and their use is pervasive. Since the initiation of trading in the first stock
index futures contract in December 1982—the Standard & Poor‟s 500 futures contract—the daily
volume of stock index futures has grown so that it now rivals the daily volume in all trading on the
New York Stock Exchange. (Volume of futures is measured in terms of notional principal, which is a
measure of exposure.)