Critiques of Derivatives – Risks & Market Concerns

"Derivatives are financial weapons of mass destruction." – Warren Buffett

Why do some experts hate them? Because they can destroy the entire economy (like in 2008).

1. Major Critiques

A. Speculative Excess

• Derivatives allow gambling with huge leverage.
• Risk: A small fall in prices can wipe out billions of dollars of capital, bankrupting banks.

B. Complexity (Black Box)

• They are mathematical monsters.
• Problem: Even the CEO of the bank often doesn't understand what traders are buying.

C. Systemic Risk

• If one big player fails (e.g., Lehman Brothers), the counterparty risk spreads like a virus to all other banks, causing a global crash.

2. Diagram: The Domino Effect

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3. Exam Notes: Writing the Answer

Question: "Critically examine the role of Financial Derivatives." (10 Marks)

Answering Strategy:

1. Start w/ Quote: Use the Warren Buffett quote for impact.
2. Pros vs Cons:
   • Pros: Risk Management, Price Discovery.
   • Cons: Speculation, Systemic Risk.
3. Conclusion: "They are like nuclear energy – useful if managed well, disastrous if mishandled."

Summary

• Tool vs Weapon: Derivatives are not inherently bad. The misuse (excessive leverage) is bad.
• Regulation: Post-2008, regulations are stricter to prevent another crisis.

Quiz Time! 🎯

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