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Understanding Derivatives In Global Crisis

Understanding Derivatives Following the Global Crisis of 2008
Graduate Finance Cluster
Professor Jeff Lee
June 15, 2009
Introduction
Even before the financial crisis of the American economy in late 2008, the understanding and uses of derivatives has been a complicated subject matter, to say the least. As a basis for a universal and fundamental conception and for purposes of this paper, the definition of derivatives with regard to financial application, per the Merriam Webster dictionary is as follows: a contract or security that derives its value from that of an underlying asset (as another security) or from the value of a rate (as of interest or currency exchange) or index of asset value (as a stock index). Investing is perilous enough when investing in plain vanilla mutual funds or stock and bonds, but it can be disastrous with the increase in complexity of many financially engineered investment products (derivatives). Following the 2007 subprime mortgage meltdown, which affected both Main Street to Wall Street, blame is being passed to identify the ultimate culprit. While the crisis associated with the subprime meltdown resulted from a combination of factors, many argue that the complexity of the derivatives products, which were developed from relatively simple mortgages, was a major contributor.
Fundamentally, there are two basic purposes for using derivatives: to mitigate risk with regard to the economic loss arising from changes in the value of the underlying asset; alternatively, to increase risk the profit arising if the value of the underlying moves in the direction they expect. These financial activities are known as hedging and speculating, respectively. These exceeding complex products are so opague thatvery few people really understand them and how they work. The more complicated the product, the less transparent the risks. This was made apparent with the recent subprime mortgage fiasco. Many investors might have understood the...