Should We Fear Derivatives: Help or Harm to the Economy
“Should We Fear of Derivatives?” is the article by Rene M. Stulz for The Journal of Economic Perspective of 2004. The main subject of this work is the evaluation of the essence of derivatives, their types, prices, and effects in the sphere of economy and clearing up why so many people still keep using derivatives and cannot leave this affair.
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The author divides this article into several logical parts in order to have time and space to explain each point about derivatives and demonstrate how he comes to these conclusions and why his conclusions have to be regarded as the correct ones. The economic essence of derivatives is hard to define. In fact, there is no concrete definition of derivatives in the economy, and this word is usually interpreted as the chemical concept of “a substance that can be made from another substance” (Stulz 173).
In finance, the essence of derivatives is almost the same. Any economic derivative is considered to be an instrument, where its payoffs are derived from some already existed values like asset or rate. Such a clear explanation of derivatives and the presentation of appropriate and interesting examples make this article really captivating from the very beginning and demonstrate how high the level of author’s knowledge is.
The clarification of the main idea is presented at the end of the introductory part. The author underlines that he intends to study derivatives as positive economic substances, represent its benefits, and mention that the risks are possible with derivatives, but still not considerable in comparison to all derivatives’ advantages.
This is why, from the very beginning of the article, it becomes clear that people should not fear derivatives in the economy because they are more helpful for this sphere of life; and in spite of possible risks and challenges, the benefits of financial derivatives are significant and important. It is necessary to become more attentive to the use of derivatives, to follow the development of derivatives, and to study the peculiarities of each derivative’s type in order to use them properly.
Derivatives may be of two types: exotic and plain vanilla. The latter is all those “contracts to buy or sell future delivery, called forwards and futures contracts” (Stulz 174). The former is everything else that may be connected and applied as the derivatives. Exotic derivatives differ from plain vanilla derivatives due to their inability to put together the contracts like forward and option.
The best example of an exotic derivative presented by Rene Stulz is any binary option, where money has to be paid in case a certain condition is met (Stulz 176). The pricing of exotic and plain vanilla derivatives remain to be a considerable topic as well, and the author pays much attention to it. A forward contract that is inherent to plain vanilla derivatives changes its values from time to time. These changes cause problems with a portfolio strategy and lead to some losses.
In order to solve the problems with pricing and get a chance to benefit from the chosen derivatives, it is possible to use the Black-Sholes formula and calculate the necessary number of shares, required time, and possible profits. The sphere of finance is always under certain development, and because of that pricing of derivatives cannot be always stable and usually depends on numerous outside factors.
Another significant part of the article is devoted to the development of derivative markets and the reasons of their growth. One of the first derivative markets have appeared several centuries ago in Holland. They were small markets for options under the influence of world economic changes like industries’ deregulations.
The demand for products was raised and used in order to prevent possible risks in the sphere of economy. The author’s attempt to describe the historical development of derivatives gives the reader a chance to comprehend why people started using derivatives and what could cause the troubles.
Derivative markets are considered to be helpful to the economy for many reasons, and Rene Stulz presents a separate part of this article in order to introduce how beneficial these markets can be. One of the most evident benefits of derivatives is their abilities to provide people and organizations to achieve payoffs, which are impossible to achieve or possible achieve but under very expensive conditions.
Derivatives are also helpful to the economy because they promote the development of underlying markets and promise their effectiveness. These benefits of derivative markets provoke numerous financial/nonfinancial firms and individuals use derivatives even if they know that they cannot hedge risks, which are associated with their capital’s values.
In this article, the risks caused by derivatives are studied as well. The financial system is one of those victims, who may lose certain profit because of the services of derivative markets. First of all, the firms, which decide to use derivatives, are not actually aware about derivatives’ worth.
Secondly, the collapse of Long-Term Capital Management’s attempts and the conditions of crisis cause considerable losses or changes of requirements frequently. But in spite of all those troubles and traps of derivative markets, people still want to address these services just in order to be sure about another opportunity to get necessary values when it becomes necessary.
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In the concluding part of his article, Rene Stulz admits that only derivatives may allow firms both financial and nonfinancial and individuals to hedge financial risks. And if derivatives undergo some changes, which may lead to their collapse, the economy as a whole takes a considerable bath.
He also answers the most important question whether derivatives are harmful or helpful, and the answer becomes clear. We should not fear them but only respect due to such a great opportunity to get payoffs, when they are necessary. The vast majority of people use planes in order to get the necessary place within a short period of time.
And though these people are afraid of flying or airplanes’ crashes, they still use these services to save time and try to improve airplane industry. Almost the same happen to the derivative markets: people are aware about the fact that risks and challenges are inherent to this financial sphere, but cannot stop using these services, because they get so many benefits, which may improve their lives.
Losses are present everywhere; each sphere of life and business is under a threat of being spoiled or crashed due to risks and crises. This is why it is not obligatory to stop using this really helpful service but start developing programs, which may improve the derivative markets’ development and make these services more effective in this world.
Stulz, Rene, M. “Should We Fear Derivatives?” The Journal of Economic Perspectives 18.3 (Summer 2004): 173-192.