Question

As you know, the derivatives are financial contracts with a value that is derived from an underlying asset. In a sense, they do not have value themselves.Over the past several years there have been calls for Congress to ban the use of derivative investing.

Assume you want to keep the derivative investing. What constraints would you impose on investment firms over such contracts?

How would they create value in the investment financial markets?

Answer 1

Warren Buffet - The Investment Legend has said that derivatives are "Financial Weapons of Mass Destruction".

The very fact that these had led to the US 2008 recession itself confirms the fact that an excess exposure to anything should simply be avoided.

Derivatives in themselves, are not so lethal as they may seem. The simply derive their value from the underlying asset and the price movement is based on the price movement of the underlying asset. Thus while i would not suggest complete banning of the same as the Congress envisages, rather i would want a few security measures and practices to be adopted so that these do remain in the market.

1. Regular monitoring of the underlying asset, the ones over which derivatives are formed should be done. There should be a limit and constraint on the % value of asset over which the derivatives can be formed. e.g if the value of the asset is $100, then constraints should allow only say 50% (just an assumption) to be encapsulated in derivative.

2. Product layering should be avoided. Eg. CDSes CDOs and their slicing to the three levels, mezannine, senior and equity etc, such kind of products should be avoided. Even if they are created there should be proper and very strict monitoring and there should be constraint on the % value of the asset which would be encapsulated in the same.

3. These kind of products should only be offered to investors who do have some kind of experience and completely understand the nuances of the complex derivative products and the losses if any that they may have to bear. Strict risk profiling would form a very major part of this exercise

4. Derivatives should only be allowed on assets which are rock solid and not something of the sort of sub-prime mortgages where the very inherent of recoveries is in major doubt.e.g. Assets like Sovereign bonds, treasury bonds, where the underlying is the backing of the US Government, these kind may be used for derivative purposes.

5. There should be no bail out package made available to the company or organization that goes bust. This is because the company would go bust due to not following the above compliances. The US tax payers should not bail them out. It is for the company and the organization to decide and repay their investors.

Derivative products created atop rock solid assets like the ones discussed above i.e. US Government Securities etc would definitely be valued. Probably even foriegn investors would make a beeline for the same.

It is not wrong to speculate on something when the underlying is strong. It would definitely create value in the long term and might lead to a futuristic financial engineering concept for other stock markets to implement. It would benefit the ultimate investors which is the basic premise for which the derivative is created.

Also one final thing is that derivatives do help to hedge ones position. So its implementation should be done in the right spirit for it to blossom. Just that nothing should be blown out of proportion.