Derivatives market dangers
Warren Buffett once referred to derivatives as ‘financial weapons of mass destruction’. Many pundits have gone as far as to warn that these instruments could bring down the financial system. But few people understand the alphabet soup of CDOs, CDSs and ABCDSs that appear regularly in the financial news. So what are derivatives and just how dangerous are they?
What are derivatives?
The first question is easily answered; the second less so. Derivatives have been around for centuries, with crude versions stretching back two millennia or more. They first evolved as a way for farmers and merchants to manage the risk of crop prices moving against them; a farmer who wanted to be certain what price he would get for his grain at harvest could use forwards or futures contracts to lock in a price in advance. In time, speculators became a crucial part of derivatives markets. They had no interest in hedging their own exposure, but instead used derivatives to bet on the prices of agricultural commodities.
The same basic principles apply today, but derivatives have become far more complex than simple punts on pork bellies. There are derivatives that allow people to bet on and hedge against movements in currencies, interest rates, shares, debt, property and more besides. The market is vast; the International Swaps and Derivatives Association (ISDA) says the total notional amount of derivatives outstanding was $236trn at the end of 2005, up 20% on 2004 (although “gross credit exposure” – the amount at risk on the contracts at any point – is probably less than 5% of that, according to the Bank for International Settlements).
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Who are the participants in a derivatives market?
There are four main types of participants in any Derivatives Market. They are:
3. Speculators and
A point to note here is that, the same individuals and organizations may play different roles under different market circumstances