Tuesday, 14 October 2008

The Crushing Potential of Financial Derivatives

There is room for derivatives on the macroeconomic scene as long as they are kept on a very short leash and used for their intended purpose which is, solely, to help producers manage the risks of dramatic changes in markets they depend upon for raw materials used in production. A prominent example of this is the commodities futures markets.

Traditionally, commodities futures were used by companies like Kellogg's Cereal as a form of “insurance” to help them manage the risk of major price fluctuations in the grains they use to make breakfast cereal. By purchasing a futures contract to guarantee the future delivery price of the grains they needed to make cereal for the consumer marketplace, they could be certain that they could maintain relative price stability at the retail level (benefiting consumers) and still operate with the profit they would need to stay in business and serve the market.

In the early 1980's, derivatives began to appear that were of a strictly financial nature. The reasoning behind their regulatory approval was that producers of financial “products” and services also needed to have similar types of “insurance” to protect them against future risks and uncertainties - just like the non-financial operators had. The main selling point was, of course, that these financial futures contracts would help financial companies to stabilize their operations and provide powerful tools to manage their risks from fluctuating markets and future uncertainties, as well. Unfortunately, these sophisticated tools that were originally intended to help firms manage risk grew into potent vehicles for leveraged speculation… and this is where the systemic problems we're facing today originated.
http://www.marketoracle.co.uk/Article6756.html

I thought to include these few paragraphs here that explain how the derivatives markets originated. The rest of the article mentions that the speculative derivatives market has expanded to over 680 trillion dollars verses the gross national product GDP of the world at 65 trillion.

[Posted at the SpookyWeather blog, October 14th, 2008.]

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