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Text Courtesy of Wikipedia From Wikipedia, the free encyclopedia
Derivatives typically have a large notional value. As such, there is the danger that their use could result in losses for which the investor would be unable to compensate. The possibility that this could lead to a chain reaction ensuing in an economic crisis was pointed out by famed investor Warren Buffett in Berkshire Hathaway's 2002 annual report. Buffett called them 'financial weapons of mass destruction.' The problem with derivatives is that they control an increasingly larger notional amount of assets and this may lead to distortions in the real capital and equities markets. Investors begin to look at the derivatives markets to make a decision to buy or sell securities and so what was originally meant to be a market to transfer risk now becomes a leading indicator.(See Berkshire Hathaway Annual Report for 2002)
[edit] Leverage of an economy's debtDerivatives massively leverage the debt in an economy, making it ever more difficult for the underlying real economy to service its debt obligations, thereby curtailing real economic activity, which can cause a recession or even depression.[citation needed] In the view of Marriner S. Eccles, US Federal Reserve Chairman from November, 1934 to February, 1948, too high a level of debt was one of the primary causes of the Great Depression. (See Berkshire Hathaway Annual Report for 2002)
[edit] BenefitsThe use of derivatives also has its benefits:
Derivatives facilitate the buying and selling of risk, and many financial professionals[who?] consider this to have a positive impact on the economic system. Although someone loses money while someone else gains money with a derivative, under normal circumstances, trading in derivatives should not adversely affect the economic system because it is not zero-sum in utility.
