They’re financial instruments whose prices are “derived” from other prices -stocks, interest rates, even commodities. Beyond that, there’s no simple definition. Businesses use derivatives to control the risk of volatile interest and exchange rates. They can also be used for speculation. Some have features that make them extremely sensitive to changes in the underlying pace.
Nicholas Leeson traded futures and options on the Nikkei 225 index. Technically, these are derivatives, since their value is based on the prices of 225 Japanese stocks. But comparing them with a derivative note whose interest payment is tied to some option-filled formula is like saying that U.S. Treasuries and the dubious obligations of a wobbly Malaysian textile maker are all “bonds.” Only the name’s the same.
It’s really more of a management scandal. As Bank of England governor Eddie George noted, Leeson “could equally have run up really huge losses in the cash markets.” The disturbing thing is not what Leeson traded but how loosely Barings supervised its traders-a critical failure. given the speed of wheeling and dealing in the computer age.
Nothing. There’s no rocket science here, none of the mind-boggling stuff that bit Procter & Gamble and killed off Askin Capital, a New York investment manager, last spring. Stock-index futures and options have been around since 1982. They’re traded on exchanges that require customers to put up money-and if a customer doesn’t pay up, the exchange must make good.
Index futures are immensely popular. On an average Chicago day, the Mercantile Exchange trades $21 billion worth of contracts on the Standard & Poor’s 500 Stock Index. Big stock investors -corporations, pension funds, mutual funds -use S&P 500 futures and options to limit their losses if stocks drop. Players in Japanese stocks do the same with the Nikkei 225. Some investors buy stock-index futures instead of stocks.
Neither. Before he changed course, he was buying and selling Nikkei 225 futures in both Osaka and Singapore to take advantage of tiny price differences between those markets. That’s low-risk, lowprofit. He didn’t trade stocks.
If your mutual fund owns index futures or options, don’t panic. Used in moderation, they may even reduce your risks. The funds that have landed in derivatives trouble either weren’t supposed to own them in the first place -primarily money-market funds -or loaded up on complicated, highly leveraged creations. Many stock and bond funds use futures and options. But checking the prospectus is confusing. You may be better off calling your investment firm. If your fund manager uses derivatives, ask for an explanation.
It’s already happening. Regulators around the world are forcing banks to keep a much closer eye on the risks of derivatives. The Securities and Exchange Commission has made companies tell stockholders more about how derivatives change their financial picture, and many annual reports now detail holdings. Dealers face more pressure to make sure customers understand what they’re buying. Derivatives trading will also be part of this year’s debate on a new banking law. The biggest issue: making sure that the government’s bank-insurance fund isn’t on the line for the next Nicholas Leeson.
