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Derivatives and Risk


There has been much discussion about the possible problems the derivatives market may cause in the future. The first thing to understand in accessing the situation is that there is not one derivatives market, but rather several cash securities markets (bonds, stocks, credit, currencies, commodities) that have derivatives traded on them. This is not an insignificant point. Problems in one market won't necessarily spill over into other markets; much would depend on the correlation exhibited. For example, I believe the equity markets have less derivative risk now than they did in 1987 (although that is not necessarily comforting given the level of risk then).

Derivatives introduce two basic risks: unknown (but quantifiable) future liability and potential leverage. The first risk means that derivatives are path-dependent: they can be worthless or worth quite a lot depending on what the underlying cash markets do and how they do it. So there can be huge amounts of open interest or contracts created in derivatives that send off alarms, but if the cash markets do nothing, neither will their derivatives. There must be a catalyst in the underlying markets, as was the case in 1998, that increases volatility to the extent that the gamma (change in the future liabilities) begins to kick in. The second risk is related: Derivatives introduce potential leverage and when leverage is increased, so is risk. Again, increased leverage is increased risk, but needs a catalyst to become a problem.

We know some facts. The notional exposure of derivatives in all markets has increased exponentially over the last ten years; some unofficial estimates are as high as $150 trillion. The largest portion of that by far is in interest-rate derivatives, which tend to be less volatile than other markets. The fastest growing area of derivatives is in credit. And the largest dealer, by far, is J.P. Morgan-Chase Bank. Another area of derivative risk is the fast growing mortgage market dominated by Fannie Mae (FNM:NYSE) and Freddie Mac (FRE:NYSE). These companies have derivative-type risk in that their future liabilities (duration) change given changes in interest rates. Freddie Mac had some bad news Monday as a reflection of the higher volatility in interest rates.

Derivatives in themselves are not a bad thing and in fact serve a very valuable economic function: breaking apart risk-return attributes. But too much of anything is bad. There is no question that derivatives have increased the potential leverage in the system. This higher leverage, all things being equal, increases volatility. Increased volatility -- although to what extent is a big question -- increases the potential for a problem, such as a failure by a major dealer, caused by derivatives. This circular causality, however, only creates the potential for a problem. It is somewhat like a speeding driver. The chances of an accident increase the faster he goes, but may be decreased by his driving abilities and other factors like the number of other cars on the road. Right now I would say the driver is going about 90 miles per hour and it is starting to drizzle.

Editors note: John Succo has written a series on derivatives which will begin running later today.
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