Cato Institute Policy Analysis No. 283:10 Myths About Financial Derivatives
September 11, 1997
Thomas F. Siems
Thomas F. Siems is a senior economist and policy adviser at the Federal Reserve Bank of Dallas. The views expressedhere are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of Dallas or theFederal Reserve System.
In ourfast-changing financial services industry, coercive regulations intended to restrict banks' activities will beunable to keep up with financial innovation. As the lines of demarcation between various types of financial serviceproviders continues to blur, the bureaucratic leviathan responsible for reforming banking regulation must face the factthat fears about derivatives have proved unfounded. Newregulations are unnecessary. Indeed, access to risk-management instruments should not be feared but, with caution, embraced to help firms manage the vicissitudes of themarket.
In this paper 10 common misconceptions about financial derivatives are explored. Believing just one or two of themyths could lead one to advocate tighter legislation and regulatory measures designed to restrict derivativeactivitiesand market participants. A careful review of the risks and rewards derivatives offer, however, suggests that regulatoryand legislative restrictions are not the answer. To blame organizational failures solely on derivatives is to miss thepoint. A better answer lies in greater reliance on market forces to control derivative-related risk taking.
Financial derivatives have changed the face offinance by creating new ways to understand, measure, and managerisks. Ultimately, financial derivatives should be considered part of any firm's risk-management strategy to ensure thatvalue-enhancing investment opportunities are pursued. The freedom to manage risk effectively must not be takenaway.
Remember the bankruptcy of Orange County, California, and the Barings Bank due to poorinvestments in financialderivatives? At that time many policymakers feared more collapsed banks, counties, and countries. Those fears provedunfounded; prudent use, not government regulation, of derivatives headed off further problems. Now, however, theFinancial Accounting Standards Board, the Federal Reserve, and the Securities and Exchange Commission aredebating the merits of new rules forderivatives. But before adopting regulations, policymakers need to separate mythsabout those financial instruments from reality.
The tremendous growth of the financial derivatives market and reports of major losses associated with derivativeproducts have resulted in a great deal of confusion about those complex instruments. Are derivatives a cancerousgrowth that is slowly but surely destroying globalfinancial markets? Are people who use derivative productsirresponsible because they use financial derivatives as part of their overall risk-management strategy? Are financialderivatives the source of the next U.S. financial fiasco--a bubble on the verge of exploding?
Those who oppose financial derivatives fear a financial disaster of tremendous proportions--a disaster that couldparalyze theworld's financial markets and force governments to intervene to restore stability and prevent massiveeconomic collapse, all at taxpayers' expense. Critics believe that derivatives create risks that are uncontrollable and notwell understood.
 Some critics liken derivatives to gene splicing: potentially useful, but certainly very dangerous,especially if used by a neophyte or a madman without propersafeguards.
In this paper 10 myths, or common misconceptions, about financial derivatives are explored. Financial derivatives havechanged the face of finance by creating new ways to understand, measure, and manage financial risks. Ultimately,derivatives offer organizations the opportunity to break financial risks into smaller components and then to buy andsell those components to best meet...
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