Derivatives are Developed in Response to Inherent Risks of Doing Business

Thousands of people who have prepared for the Series 3 exam (commodity futures broker license exam) in the United States know that the futures markets developed in the United States during the 1840s as an answer to the gluts and shortages associated with the harvest cycle that naturally occurs with the seasons of the year. They developed as a means for farmers to transfer the risk of price change to speculators who were willing to assume that risk and hopefully earn a profit. The speculators supplied the capital the hedgers needed to make it through the lean times to the next harvest. Notice that the risk came first and the means to transfer the risk was developed in response to the risk.

Throughout the late 1800s and early 1900s, as the U.S. economy grew, new futures markets (a form of derivative) developed for other commodities as the usage of those commodities expanded. Think of meats, butter, metals, and rubber, to name a few commodities. It was only natural that derivatives would be developed to help transfer the risk associated with doing business with these commodities as well.

More recently, in the 1970s, we saw the need for new futures markets. It became necessary to develop currency futures after the United States closed the gold window and the world was changed to a fiat-currency-only market. Because fiat currencies have no commodity backing, the only question at that point became, “Which currency is going to inflate faster relative to the others?” For multi-national businesses, it became a necessity to hedge against the inherent risk of doing business in many different countries, each with its own fiat currency.

Shortly thereafter, as inflation began to heat up, interest rates became more volatile (inflation is one of the components of interest) and the financial futures markets were formed as a means to hedge against the risk of interest rate change. Furthermore, U.S. T-Bonds became much more widely used as a means of financing the government's deficits and a T-Bond futures contract was invented.

In the mid 1990s, with loan defaults on the rise, a new derivative was developed to guard against the risk of debtor default. It was called a credit default swap (CDS)! But it wasn’t until 2003, that the rate of defaults rose dramatically and credit default swaps came into their own. The need to hedge against the default of ever riskier debtors (counter-party risk), became a tool for financial survival in the hands of the skilled, and a tool of destruction in the hands of the unwary. Eventually, CDSs could be purchased to “insure” against the collapse of any debtor! And, as the government-created credit expansion continued, the need to hedge against defaults grew, fostering the growth of the swap market. Today, there are $62 trillion in credit default swaps, according to The International Swaps and Derivatives Association Inc. and the Bank for International Settlements.

In short, the U.S. government has been the cause of the risks people have been hedging against for at least the last 40 years. This trend will undoubtedly continue to grow into the future as the government expands the U.S. dollar supply, extends loans at below market rates of interest, “purchases” interests in corporate America, and raises taxes. In summary, it is the U.S. government that is the most serious source of risk to capital accumulation. At some point, we will need a way to hedge against the loss of capital and dominance of destructive government programs.

Robert Jackson Smith

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