In Defense of derivatives: between Enron, WorldCom, and Global Crossing, the controversial financial instruments have gotten a bad rap. Here's the truth

Reason, Feb, 2004 by Gene Callahan, Greg Kaza

Consider a simple derivative, such as a stock option. Let's assume you could buy a share of IBM stock today at $100. Alternatively, you could buy an option granting you the right to buy a share of IBM stock at $100 at any time during the next six months. It should be clear that if you are interested in owning IBM you probably would consider such an option valuable. After all, should the share price of IBM plunge in the next half a year, you need not exercise your option, saving you from taking a bath. On the other hand, if IBM rises above $100, you can exercise your option and immediately make a profit.

The essence of derivatives is that they allow investors to separate out various aspects of an asset, and trade those aspects separately, rather than in a bundle. For example, when purchasing a share of common stock outright, the buyer gets both the upside and the downside potential of the stock. But by purchasing a "call" option, the buyer acquires only the upside potential.

Or consider David Bowie's sale of his royalty income, which separated the income stream from his song rights from the rights to the songs themselves. While the singer still controlled the use of his own songs, all of the royalty income from them flowed to those who bought the Bowie Bonds. From Bowie's point of view, his financial future was too dependent on the vagaries of his popularity. By selling some of his royalty income to others, Bowie was able to diversify his investments. (We assume that he did not spend the entire $55 million on a huge shopping spree for his supermodel wife Iman.) He reduced the risk that a major shift in the public's musical taste would leave him a pauper. Meanwhile, investors who had not previously had any stake in the sales of ziggy Stardust could diversify into that area and earn a decent interest rate while doing so.

Similarly, a farmer who does not wish to concern herself with the dynamics of the wheat market can sell her crop "forward" (i.e., sell it at a specified future date for a price determined today), she can gain even more flexibility by purchasing a "put" option on the wheat--buying the right, but not the obligation, to sell her crop at a certain price (the option's "strike price") over a specified period of time. If the spot wheat price falls below the strike, she can exercise her option and protect herself from losses. If the price rises above the strike, she can let the option expire and sell her crop at the higher price. Naturally, such flexibility has value to the farmer, and she must pay a price to others to persuade them to take on some of her risk.

"It is widely recognized that OTC ["over-the-counter" i.e., not traded on an exchange] derivative instruments are important financial management tools that, in many respects, reflect the unique strength and innovation of American capital markets," said Arthur Levitt, then chairman of the Security and Exchange Commission, in 1998 testimony to Congress. "OTC derivative instruments provide significant benefits to corporations, financial institutions, and institutional investors by allowing them to manage risks associated with their business activities or their financial assets. These instruments, for example, can be used by corporations and local governments to lower funding costs, or by multinational corporations to reduce exposure to fluctuating exchange rates."