Derivatives: Understanding Their Usefulness and Their Role in the Financial Crisis

Abstract

This article makes two main arguments that are intended to guide policymakers and regulators of financial markets: (1) when used properly, derivatives are enormously useful to companies in managing business risks; and (2) neither derivatives nor derivatives‐related products played significant roles in causing or exacerbating the financial crisis of 2007–2009.The author begins by illustrating the corporate use of derivatives with a detailed example of how a large brewer uses both exchange‐traded wheat futures and over‐the‐counter aluminum swaps to hedge the risks of higher wheat and aluminum prices. In the process, the value of much‐maligned OTC derivatives, and the role of financial intermediaries in facilitating their use, are clearly demonstrated.The second part of the article refutes the popular claims, widely expressed in the media and on Capitol Hill, that derivatives were at the heart of the financial crisis. Losses and failures during the crisis are shown to have resulted primarily from excessive non‐derivative leverage and from investments in non‐derivative mortgage products that fell dramatically in value. The only significant exception involved the insurance company AIG, whose failure and bailout are attributable not only to large losses on credit default swaps, but to comparable losses on non‐derivative mortgage products. Moreover, by the time AIG failed, many other large financial institutions had already either failed or experienced large losses. What's more, and all but forgotten during the controversy, some large banks were able to reduce risk by hedging with those derivatives.