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Americans Need to Understand Derivative Markets

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Derivative markets are complex. While they have become necessary for our large economy to function, they also present huge risks.

Derivative markets are complex. While they have become necessary for our large economy to function, they also present huge risks.

First of all, derivatives are a class of investment. They are mostly contracts based on market movements. These contracts are for a specific period of time. So why are they necessary? Most importantly, they allow money to flow at higher levels which is needed to support an economy the size of the United States. Without derivatives, banks would not be able to operate in today's environment. They need a continuous flow of money to survive.

Derivatives are also used to reduce risk. Hedge funds are an example of derivatives that are used to offset the risk of traditional investments such as stocks. They have a stabilizing influence that allows markets to trade at much higher levels.

It may be difficult to understand, but our recent financial crisis was caused by the derivatives market. In particular, credit default swaps were sold as a form of insurance to protect investors against losses in mortgage backed securities. These instruments were sold in many layers that created a market bubble with little regard for the valuation of the underlying securities. This created a panic as other areas of the economy are dependent on the derivatives market. The stock market lost 50% of its value as a result. For those who are in doubt, please consider that the size of the underlying real estate market is not sufficient to move the broader market in this way.

Derivative markets are unregulated. They exist without any central authority. Why is this bad? Derivatives markets are so large, they can upset the delicate balance of capital and trade. Unfortunately, they are created and sold with only a perception of value based on the markets themselves. This is dangerous as they are now layered so deeply that no one really knows what they are worth. It is based on pure speculation.

I believe that we need some form of exchange to handle derivatives and some form of oversight to prevent abuse. I am not for big government, but this is not a black and white issue. It requires a great deal of understanding without political influence. I am somewhat troubled by the tendency of the American people to rally around partisan rhetoric, calling for one extreme or the other. In this particular case, an extreme in either direction will be disastrous.

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