Derivative Markets Controversy
Reasons Why Derivatives Are Often Subjected to Severe Criticism
Derivatives are complex financial instruments that can result in significant losses in the hands of investors who failed to understand them thoroughly.
Over the years, derivatives have been subjected to much controversy, if for no other reason but for being too complex, yet readily available to ordinary, inexperienced and hardly knowledgeable investors. Alexander Pope once said, “A little learning is a dangerous thing.” Indeed!
How Derivatives Work
When homeowners take out a mortgage to pay for their homes, besides literally signing their lives away to banks, they also receive an extremely valuable embedded derivative—an option to prepay a part or an entire mortgage. Homeowners usually have the incentive to use that option when interest rates fall and refinancing bonanza ensues.
Notably, prepaying a mortgage results in enormous interest savings for the homeowner. Yet, derivatives are a zero-sum game; meaning, for one party to profit, the other has to lose. So, if the homeowner is capturing all the interest savings from the mortgage prepayment, who is paying for it?
When homeowners take out mortgages, these are often packaged by the lenders into pools and sold as asset-backed securities to other investors, which can be financial institutions, as well as small companies or even individual investors. Recent credit crunch in the U.S. has revealed one scary truth, which is that many buyers of asset-backed securities were poorly informed about securities they were holding in their portfolios.
Going back to the question who pays for interest savings when homeowners prepay mortgages, well, that would be the holders of asset-backed securities. When unsophisticated holders of asset-backed securities lose money on their investments, they rarely blame themselves for not bothering to find out more about what they were buying, but rather place all the blame on derivatives alone.
On the other hand, it is not as if no one had profited from holding derivatives. Homeowners who prepaid their mortgages ended up pocketing all the interest savings also from holding derivatives.
So who is to blame really? Most likely that would be financial institutions that have packaged the mortgages in a portfolio of asset-backed securities and sold them to investors who had no clue what they were buying.
Derivatives Are Not Legalized Gambling
One of the often heard myths about derivatives is that they are nothing more than some form of “government-sponsored” gambling in the financial markets. Agreed, both hedgers and speculators are essentially “betting” the market is either going up or down. However, the benefits derived from derivatives trading are much more than sheer, dumb luck won by few.
While there are parties that profit from gambling, derivatives trading not only helps productive members of the society to manage risk, but also contributes to efficient markets. Meaning, derivatives trading creates social benefits. On the other hand, organized gambling hardly creates more efficient societies, and it certainly comes at considerable social costs.
