Financial Derivatives: What You Should Know

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A recent trading loss at JPMorgan Chase is raising new concern about bank rules and financial regulations in the U.S.

The bad bets that cost JPMorgan $2 billion were based on so-called credit derivatives.

Billionaire investor Warren Buffet has called derivatives "financial weapons of mass destruction." And others warn that JPMorgan's loss in derivatives trading is not an isolated case.

Still, few people really understand what derivatives are or how they work.

The Origin of Derivatives

Phil Kerpen, a policy analyst at Americans for Prosperity, which is a group promoting free markets, says the origin of derivatives was innocent enough -- farmers wanting to protect the price for their crops.

"A farmer in the field didn't want to risk it that when his crop came in," he explained. "He wouldn't be able to get the price that he wants. He might go to a grocer and say 'Let's agree that on this future date I'll sell to you for this price.' And that's what's called a forward contract."

The grocer would agree, because he knew he would get the product he needed that year at a guaranteed price. So both the farmer and the grocer came out ahead, whether it was a bad year or a bumper crop.

The contract is a 'derivative' because it's derived from something else - the crops and the agreed-upon price for them.

Deals About Assets Sometimes Are Just Bets 

So derivatives are not actually assets, but deals made about assets. And in many cases, they are just bets.

"Let's say you're in the oil business and you're going to sell a lot more heating oil, if it's a cold winter," Kerpen told CBN News. "You might want to bet against a cold winter, so that if there isn't one, you'll make more money that way and it'll smooth out your risk."

Over time, the derivatives market exploded, from simple futures contracts for farmers to almost anything.

There are all kinds of financial assets in the world, including stocks, bonds and commodities like gold, oil, grains to name a few. Today you can bet on all sorts of derivatives for almost any of them, whether their value will go up or down, how the weather might affect them, etc.

Michael Mackenzie of the Financial Times points out there are frightening aspects to derivatives.

"A hedge fund has much, much greater credit risk if you're trading with them," he said.

One of the biggest dangers is tied up in what's called counterparty risk, where several firms may be involved in one derivatives deal. And that leads to a serious risk.

"[Because] if they fail, it's like a chain of dominoes," Mackenzie explained. "Once one person stops paying, then all these other trades that have built off that first trade are also under threat."

*Originally aired May 14, 2009 

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Paul  Strand

Paul Strand

CBN News Washington Sr. Correspondent

As senior correspondent in CBN's Washington, D.C., bureau, Paul Strand has covered a variety of political and social issues, with an emphasis on defense, justice, and Congress.  Follow Paul on Twitter @PaulStrandCBN and "like" him at