What exactly is considered a derivative and why do many people consider them to be bad? Are they? Also, what role did derivatives play in the most recent recession?
Derivatives are financial products whose value is dependant on an other good. For example an option, the right to buy or sell a given ressource in a given amount of time. But they can be also massively more complicated. An example are mortgage bundles that are mortgages with different risks mixed in certain ratios. Many people consider them bad because they are unpredictable in their behavior, more than other financial instruments, e.g. shares. This risk would be accounted for in a free market but in a hampered market theese derivatives got AAA ratings by law since mortgages were protected. Thus I conclude that derivatives are not inherently bad, only in an hampered market. In the most recent recession derivatives from mortgages possibly played a role but that should be answered by an other user.
What law made these derivatives AAA? I thought credit rating agencies (Moody’s, Standard and Poor etc) gave credit ratings?
Derivatives played absolutely zero role in the recent recession.
The blame game was put on asset-backed securities. Sometimes, a specially incorporated corporation will buy bonds with high risk of default with high rates of interest and sell their own bonds with a mixture of very low risk bonds with very low rates and very high risk bonds with very high rates - the payment preference is given to the low risk bonds. In case of default of the first layer of bonds, it is possible that only the low-riskers get all their money back while the high-riskers get nothing.
That way, a BBB rated bond can be “broken” into two AAA and CCC bonds, so to speak! People consider it to be a form of “fraud”, because it allows high risk bonds to be issued as low risk bonds, but it is perfectly acceptable, because there is preference in repayment, thus lower risk and higher credit rating. In fact, it reduced the damage from the recession, because low riskers were protected and all the burden of recession was put on high riskers.
Finance is my weak area. What is a “preference payment”?
What exactly is considered a derivative and why do many people consider them to be bad? Are they? Also, what role did derivatives play in the most recent recession?
What Does Derivative Mean?
A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.
Investopedia explains Derivative
Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Derivatives are contracts and can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region.
Derivatives are generally used as an instrument to hedge risk, but can also be used for speculative purposes. For example, a European investor purchasing shares of an American company off of an American exchange (using U.S. dollars to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into Euros.
During the boom, all the major banks and hedge funds were engaging in high risk speculation and derivatives were the instrument of choice. They are an easy scapegoat because the average person doesn’t know anything about economics or finance, including what a derivative is.
A derivative is a bet and a bet is a derivative – usually between two (counter-)parties. The pay-off from a derivative (or a bet) contract is usually linked to some future outcome. Trading a derivative (or entering a bet) is a voluntary exchange of one future pay-off distribution for another. Nothing more, nothing less. For example: You pay me $5 in October for my obligation to pay you $50 if Feb snowfall is > 2ft, which would help toward paying your snow-plowing bill that month. As with any other voluntary exchange, there’s nothing inherently wrong with them.
A problem arises when – through the magic of central banking, fiat money, and state guarantees – entities entering these contracts are entitled to all the benefits of the positive pay-off outcomes but not responsible for most of the negative (loss) outcomes. Bullets (or, in this case, derivatives) don’t hurt people. People do.
Z.
Stephen: “During the boom, all the major banks and hedge funds were engaging in high risk speculation and derivatives were the instrument of choice. They are an easy scapegoat because the average person doesn’t know anything about economics or finance, including what a derivative is.”
Prateek Sanjay: “Derivatives played absolutely zero role in the recent recession.”
It seems to me that Stephen and Prateek Sanjay have opposite opinions on the role derivatives played regarding the 2008 financial crisis. Who is more correct?
Read my post. What role did bullets play in the Holocaust?
Z.
I am not on the opposite side of Stephen.
I agree with him that derivatives are a scapegoat. I just gave the other side of the issue of people who consider it fraud.