The Corner

In Defense of Derivatives

There is a very interesting article about derivatives in this morning’s Wall Street Journal. The author, Rene Stulz, a professor of finance at the Fisher College of The Ohio State University, explains very clearly the pros and cons of derivatives, their role in the AIG debacle, and what to do about it, if anything.

He writes:

There are two sides to derivatives — one positive and beneficial, one exploitive and negative. Of the latter, the most visible example today comes to us courtesy of the American International Group (AIG) and reveals what happens when a lightly regulated but highly interconnected financial institution ends up positioned in a way that it cannot survive a housing crash and then such a crash occurs.

The other side of derivatives, however, involves the less-publicized but widespread use of these financial instruments in ways that benefit companies. Derivatives have been immensely valuable tools and will be instrumental in providing the liquidity needed to jump-start the economy. Derivatives are used by a vast number of U.S. companies, both small and large, to manage various risks that arise in connection with their businesses.

He shows that derivatives are remarkably important for Main Street companies, as they ”help insulate them from risk, which allows them to borrow capital at better prices than they would otherwise. And derivatives are more useful than ever in these days of unusual volatility in financial markets.”

He concludes:

Our businesses need derivatives. Most of us choose to drive cars even though they sometimes crash. But we also insist that cars are made as safe as it makes economic sense for them to be, and that speed limits and other rules of the road are enforced. The same logic should apply to derivatives.

To read more go here.

For the finance illiterates like me, read these two very informative and easy to understand four-page articles. The first one is by New York University professor Lawrence White on the role of capital and leverage in the financial debacle of 2007-2008. The second one is by my Mercatus Center colleague Houman Shadab on hedge funds and the financial crisis.

And for many more articles on the financial crisis go here.  

Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.

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