Covering Globalization: A Handbook for Reporters

By Anya Schiffrin; Amer Bisat | Go to book overview

CHAPTER SEVEN
DERIVATIVES

RANDALL DODD


INTRODUCTON

DERIVATIVIS SERVE an important and useful economic function, but they also pose several dangers to the stability of financial markets and the overall economy. They are often employed for the useful purpose of hedging and risk management, and this role becomes more important as financial markets grow more volatile. However, they can also be associated with massive market failings whose consequences can be tragic. Most remember the LTCM episode, when this major hedge fund’s derivative headings imploded, nearly bringing down with them the global capital market as we know it.

As the name suggests, a derivative is a financial contract whose value is linked (“derived”) to the price of an underlying commodity, asset, rate, or index. Derivatives markets also serve to determine the prices of many assets and commodities and the economic value of nonmarket events such as the weather. However, they are also used for unproductive purposes Such as avoiding taxation, outflanking regulations designed to make financial markets safe and sound, and manipulating accounting rules, credit ratings, and financial reports. Derivatives are also used to commit fraud and to manipulate markets.

Derivatives are powerful tools that can be used to hedge the risks nornrtally associated with production, commerce, and finance. Derivatives facilitate risk management by allowing a person to reduce his exposure to certain kinds of risk by transferring those risks to another person who is more willing and able to bear such risks. Farmers use derivatives to hedge against a fall in the price of their crop before the crop can be harvested and

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