There are a host of “financial products” in addition to shares of stock whose justification is risk management for investors and the generation of information about what investors expect to happen.  In reality they often serve only to permit speculation about price fluctuations in financial markets.  Even mainstream economists no longer hesitate to use the term “bet” when describing financial investments, especially investments in derivatives.

Risk management for an investor seems comparable to insurance against accidents or natural disasters. A credit default swap seems on the surface to be a form of insurance against default on a loan. It is dressed up as a “financial product” to avoid regulations aimed at insurance policies. It also is available to someone who has no stake in the underlying loan, and the payoff in the event of default can be enormous, as a few prescient investors saw during the 2007 financial crisis. Credit default swaps are justified as a means of maintaining liquidity and as a source of information about the prospects of the borrowers. This is comparable to the idea that gamblers who determine the odds know more about the possible outcome of a sporting event than the players, coaches and scouts involved.

Another metaphor for risk management is “hedging” a bet. In certain circumstances a gambler who is betting on a long shot can place a second bet which will limit his losses or even guarantee a profit if his long shot does not come through.[see “How to hedge a bet for guaranteed profit“] Hedging an investment was originally a strategy of holding both “long” and “short” positions in a stock. A “short” position essentially involves selling share you do not own, and is made possible by a broker who is willing to “lend” you a number of shares to sell at the current price and allow you a certain amount of time to buy shares to return to the broker. The broker cares only about the number of shares, and you are gambling on the price of the share going down.

Today’s “hedge fund” is an investment fund set up as a partnership so that it is not subject to the same kinds of regulations as publicly traded mutual funds. Hedge funds use every conceivable type of derivative to maximize their returns. To a naïve moralistic outsider derivatives just seem to offer exotic forms of gambling, but defenders of the faith will argue that derivatives allow individual investors to manage risk, and even make the financial markets more efficient and less volatile. The two views may not be contradictory.

^BackToTop