Derivatives adding risk

Do derivatives add risk because of the secondary markets' lack of liquidity? This question is inspected on the New Economist web site in the article Derivatives: adding risk, or reducing it?. In recent years, investment firms have done very well by trading in credit risk derivatives. This article brings up the question of inefficiencies in the market, from poor book keeping to liquidity issues in secondary markets. Also, questions of SEC regulation inefficiencies have been of concern for years, and I suspect that when the SEC gets around to regulating the derivatives markets that hedge funds will have lower returns.

1 comment:

Dr. Tufte said...

-1 on Frank's post for a spelling error.

One of the big unsolved mysteries in finance is when is it OK to add risk.

Finance focuses so much on reducing risk - not because that is necessarily better - but because that is something they know how to do. Risk reduction is great, provided that returns don't drop too much. The beauty of diversification and hedging is that they fit that bill.

But ... the theory has no flip side. What if you could raise risk a bit but get returns to go up enough to compensate you more than adequately. Clearly that is something you should go forward with, but we don't have a theory of how to make that choice.