INVESTING: The rise of derivatives: an innovation to cheer, not fear

After I read about a new futures contract at the Chicago Mercantile Exchange that allows traders to place hedges on snowfall amounts in various areas, my first reaction was, that’s cool.

I am a geek about my business, and I love the way the industry is constantly innovating. The weather contract is called a derivative, and I can remember not too long ago a lot of people were worried about derivatives.

A derivative is a contract whose price is dependent upon an underlying asset, like a stock or a bond. For example, you can buy a share of IBM, or you can buy a call option on IBM for far less money. The IBM call option will move higher if IBM trades up. In addition to being far less expensive than the underlying asset, the option has a time component to it. At the end of a previously agreed upon time frame, the option expires.

In the history of modern finance and stock exchanges, derivatives are fairly new. The Chicago Board of Options opened only in 1973. But as our economies have grown and globalization pushes ahead, demand for derivatives has exploded.

By the late 1990s, they were so popular that Alan Greenspan began questioning their effect on our financial markets. He said there was no way of knowing the total value of all derivatives in the world, and he seemed to think that lack of knowledge was dangerous.

Boiled down, we are talking about contracts. Greenspan was concerned that the value of these instruments escalated so high that a quick unwinding would create havoc in our system. But typically, there are almost as many contracts going one way as another. If the stock market began melting down, the options market might actually serve as a circuit breaker. People can fly to the negative side so fast today that an outright crash might be avoided.

These underlying instruments allow people and institutions and companies to manage risk in different situations. A U.S.-based company that does a lot of overseas business can smooth out currency volatility.

An individual living in Phoenix who doesn’t want to sell his house can profit if the Phoenix real estate market cools a little. A surf shop on the beach can protect itself from a slow summer if it rains every weekend. And in the derivative market, there is always someone else on the other side of the trade.

Hey, just for fun, you can buy a little satisfaction from a vacation you have planned. Buy a rain contract for the place you will be visiting, and if you get rained out, at least you made a little money from your misery.

The growing derivative market is simply the economy’s answer to a need. Our government tries to safeguard us from all sorts of potential problems, but I think the free market can do that a lot more efficiently. Options and futures give us a greater number of choices. And even though they are used in many cases to reduce risk, they may end up encouraging a higher level of risk taking, which is one of the cornerstones of our growth to begin with.