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If you find the size of the derivatives market frightening then you are still sane. Derivatives evolved out of ways of managing financial risks. For example, you want the certainty of knowing the price that your harvest in 6 months time will sell for. Or you want to know what your oil will sell for next year. So you buy an option to sell in the future at an agreed price. If you think about it the person or company selling that option is making a bet about what future prices will be. If, for example, they agree to buy your oil at $60 dollars a barrel in a years time when the current market price at that time turns out to be $30 then they have lost the bet. If you take up the option and sell your oil at $60 then they would have to take delivery and buy it at that price. But to sell it on into the market they would only get the current $30.

You can look at derivatives as insurance deals to manage risk of what might happen but, from another perspective, one person’s insurance deal is a bet to their “counterparty”. There’s no guarantee that, on a mass scale in a mega financial crisis, the companies or individuals who are the counterparties apparently insuring others, will actually be able to pay up if they lose on a big enough scale. Derivatives can give the appearance of making things safer so encourage more risk taking but these “insurance deals” could go mega sour if some of the finance institutes making them go bust and then don’t pay up when they are supposed to. That’s like finding your insurance company going bust just when you need them. There could then be a domino chain of busts. In the words of one very rich man, Warren Buffet, derivatives are “financial weapons of mass destruction”.

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