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Financial derivatives and their importance

The world financial markets, as we all know, went belly up of late and investors lost money by the bucketful. Through the course of it all, there were several terms that were thrown about that were treated as worthy of widespread scorn. Among many of these objects of ire and derision were  financial derivatives, treated as trading simply for the mere sake of trading and financial speculation pure and simple. They were touted as being completely unrelated to the financial need of any average retail investor, instead becoming symbolic of corporate greed. Of course, in the mad rush of the time and the fury that was there, someone or something had to be blamed for sense to be made of it all and financial derivatives were one of many instruments that were railed against.

But there is more to this than just a beast-like demeanor that caters to its corporate overlords. Ironically enough, the origins have been traced back to being born out of the needs of ordinary people. Farmers in the mid-west were in financial ruin at one point in time during the 1800’s due to a huge degree of volatility in the price of cereals. There were just too many costs involved for farmers that means it became difficult for them to get any sort of money out of their efforts for themselves. The idea then was to use a simple fixed price that offered them a better chance of turning a profit and that was when the first corn contracts were signed on 13th March 1851, the first financial market of its kind. Speculators offered fixed prices in the future, leaving the farmers free to do what they do best.

It took nearly a century before this concept was translated into forward hedging for anything more than the farming community and again, necessity was the mother of invention. As exchange rates fluctuated more than a woman’s moods on a particularly volatile day, there was a need to stabilize things and bring a semblance of sense to the chaos that was prevalent at the time. With time, several layers were added making it more complex than ever, and in the last three decades alone there were options on futures during the ’80s, after which there were over-the-counter swaps and then credit derivatives in the 1990’s and the rise of insurance derivatives by the turn of this millennium.

And so the market kept on growing and it is now the inability of computers to manage risk at the rate of light speed that causes a risk since the markets seem to move at times faster than computers can at times manage. Ultimately, it is the inability to manage risk that must be blamed and not the financial vehicle in question. Financial derivatives have created new ways for risk to be understood, pre-empted and managed and they should be considered an essential part of a well-rounded risk-management program. The ability to manage risk better must not be nullified and that’s where financial derivatives play a key role.

Desc: Financial derivatives should be considered an essential part of a well-rounded risk-management program.