Arnold Kling

Derivative Abuse

Arnold Kling, Great Questions of Economics
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Financial derivatives have been involved in many recent prominent corporate implosions, including Enron's. Derivatives are like a strong medication that can be helpful when used properly and dangerous when abused.

In the opinion of Andrew Hofer, poorly thought-out financial regulation actually drives many of the abuses. For example,

Insurance companies need yield. So derivative salesmen see an opportunity to engineer around the regulations. They package securities that substitute price volatility for the proscribed credit risk.

The problem is that certain types of risk are monitored and restricted by regulators, but other types of risk are not. Institutions head toward the unregulated risk.

One key to proper management and regulation of derivatives is making sure that the market value of positions gets reported regularly. Instead, in many cases, accountants allow a company to report positions at book value rather than at current market value. When regulators go along, this is a recipe for catastrophe.

Along these lines, Hofer points out

Regulations that focus on complete disclosure are much more effective than those that attempt to dictate behavior, and they impose less of a burden on the regulated entity.

Discussion Question.

Are market incentives sufficient to promote better disclosure of companies' dealings in derivatives, or is government regulation the only solution?

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