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Finacial Derivatives

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Demystifying
T
20 The Milken Institute Review
The Merriam-Webster dictionary defi nes a derivative in the fi eld of chemistry as “a substance that can be made from another substance.” Derivatives in fi nance work on the same principle.
These fi nancial instruments promise payoffs that are derived from the value of something else, which is called the “underlying.” The underlying is often a fi nancial asset or rate, but it does not have to be. For example, derivatives exist with payments linked to the S&P
500 stock index, the temperature at Kennedy Airport, and the number of bankruptcies among a group of selected companies. Some estimates of the size of the market for derivatives are in excess of $270 trillion – more than 100 times larger than 30 years ago.
When derivative contracts lead to large fi nancial losses, they can make headlines. In recent years, derivatives have been associated with a few truly notable events, including the collapses of Barings
By René M. Stulz
Financial
Derivatives
Third Quarter 2005 21
Bank (the Queen of England’s primary bank) and Long-Term Capital
Management (a hedge fund whose partners included an economist with a Nobel Prize awarded for breakthrough research in pricing derivatives). Derivatives even had a role in the fall of Enron. Indeed, just two years ago, Warren Buffett concluded that “derivatives are fi nancial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” michael morgenstern
22 The Milken Institute Review
But there are two sides to this coin. Although some serious dangers are associated with derivatives, handled with care they have proved to be immensely valuable to modern economies, and will surely remain so. the nuts and bolts
Derivatives come in fl avors from plain vanilla to mint chocolate-chip. The plain vanilla include contracts to buy

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