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HICKS: Derivatives don't deserve their scary reputation

June 12, 2010

Following the financial crisis of 2008, it seemed natural that Congress would seek to control an increasing part of the markets in which financial services are bought and sold.

I, like most Americans, feel that some review of regulation is warranted. That debate is well under way, and whatever emerges from Congress in the coming weeks will contain both good and bad public policies. How much of each is not yet knowable.

One major part of the legislation will target derivatives. This is an arena where the financial services industry does itself no good from a public relations sense. Derivatives, in and of themselves, are fairly harmless and easy to understand. But the industry jargon makes it seem more mysterious and arcane than necessary, and that is part and parcel of bad press the industry currently endures.

In its simplest form, a derivative is simply an agreement about an exchange—a future purchase or sale. For example, if you agree to subscribe to this newspaper next year and I agree to write the columns, that is a derivative. When you actually buy the newspaper, or I write the articles, it is no longer a derivative, but a tangible asset (or debt depending on how you view this column).

Derivatives are critical for reducing risk to buyers and sellers. In fact, farmers are the chief beneficiaries of derivatives markets of a particular type we call commodities. In these markets, a farmer either agrees to sell some amount of produce in the future or decides how much corn or soybeans to plant based upon the price after harvest. These markets make prices more stable and help even those who don’t buy or sell in them.

Lots of other derivatives seem more complicated, but do the same thing. For example, a bank may buy lots of government bonds, which are generally safe and secure. But, knowing that California is in the mix, they might look for another bank who would agree to pay a certain amount if the California bond defaults. This agreement can be worked out based on calculations by both banks. The reason for doing so isn’t that one side thinks its calculations are better than the other (they usually aren’t) but rather that it spreads the risk to more people. By the way, this is called an over-the-counter credit default swap.

This may sound like chicanery, but it ain’t. Most of us do the same thing. I have a term life insurance policy that expires at age 67 and a retirement savings account that I cannot use until I am 67. Clearly, I will use only one of these, but having both reduces my (and my family’s) financial risk.

This is not to say the financial services industry is without chicanery and crooks. It surely has its share, as does the clergy, medicine and used-car dealerships. Without these financial services, we would all be a lot poorer and face a more, not less, uncertain economic future.•

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Hicks is director of the Center for Business and Economic Research at Ball State University. His column appears weekly. He can be reached at cber@bsu.edu.

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