In 1988 Alan Greenspan who was then the Fed chairman observed that the reason why the equity derivatives market has grown by leaps and bounds is because these financial derivatives provide the users with great economic value (Cuny, 2006). However, Warren Buffet in 2002, expressed a different opinion on the same financial derivatives, when he referred to them as “weapons of mass destruction”. One is thus left to wonder how two financial gurus could such opinions that are worlds apart.
In a broad sense financial derivatives refer to any financial contract whose value is derived from the underlying asset. Generally, investors of derivatives gain profits from; interest rate changes and equity markets globally, shifts in currency exchange rates, and changes in global demand and supply for commodities e.g. agricultural products, energy products such as oil, and industrial and precious metals. Specifically, an option is a derivative that represents a contract purchased by one party ( option holder) from another party (the option writer). This contract grants the buyer a right to buy or sell a security at a pre-defined price agreed upon on a specific date or during a certain period of time.
The derivative market’s most important purpose is risk management (Obiri, n.d.). Options and other financial derivatives are used by investors for both speculation and hedging. The financial derivatives market has grown largely due to the desire of investors to manage their risk in the complex global markets. Given the rapid growth of the derivative market, it is a grave mistake for Warren Buffet to simply refer to derivatives as “a financial weapon of mass destruction”. However, as the former SEC chairman Arthur Leavitt’s noted, derivatives are like electricity; bearing the potential of doing good but dangerous if mishandled.
Work Cited
Cuny, C. (2006). Why derivatives on derivatives? The case of spread futures. Journal Of Financial Intermediation, 15(1), 132-159. http://dx.doi.org/10.1016/j.jfi.2004.12.003
Obiri, C. The Dangers of Complex Investments: Risk Management in Derivatives Trading. SSRN Electronic Journal. http://dx.doi.org/10.2139/ssrn.2035988
