Complex Derivatives

Abstract

The intrinsic complexity of the financial derivatives market has emerged as both an incentive to engage in it, and a key source of its inherent instability. Regulators now faced with the challenge of taming this beast may find inspiration in the budding science of complex systems. When financial derivatives were cast in 2002 as latent 'weapons of mass destruction', one might have expected the world at large to sit up and listen — particularly in the wake of subsequent events that led to the financial crisis of 2008. Instead, the derivatives market continues to grow in size and complexity (Fig. 1), spawning a new generation of financial innovations, and raising concerns about its potential impact on the economy as a whole. A derivative instrument is a financial contract between two parties, in which the value of the payoff is derived from the value of another financial instrument or asset, called the underlying entity. In some cases, this contract acts as a kind of insurance: in a credit default swap, for example, a lender might buy protection from a third party to insure against the default of the borrower. However, unlike conventional insurance, in which a person necessarily owns the house she wants to insure, derivatives can be negotiated on any underlying entity — meaning anyone could take out insurance on the house in question. Speculation therefore emerges as another reason to trade in derivatives. By engaging in a speculative derivatives market, players can potentially amplify their gains, which is arguably the most plausible explanation for the proliferation of derivatives in recent years. Needless to say, losses are also amplified. Unlike bets on, say, dice — where the chances of the outcome are not affected by the bet itself — the more market players bet on the default of a country, the more likely the default becomes. Eventually the game becomes a self-fulfilling prophecy, as in a bank run, where if each party believes that others will withdraw their money from the bank, it pays each to do so. More perversely, in some cases parties have incentives (and opportunities) to precipitate these events, by spreading rumours or by manipulating the prices on which the derivatives are contingent — a situation seen most recently in the London Interbank Offered Rate (LIBOR) affair. Proponents of derivatives have long argued that these instruments help to stabilize markets by distributing risk, but it has been shown recently that in many situations risk sharing can also lead to instabilities