Thanks to the goings on in Wall Street over the weekend, various newspapers are busily producing panic-filled articles about evil things called “derivatives”. This happens to be something I know a little about. Those of you who have a faith-based view of economics need read no further, but if you are interested in some more information, here it comes.

A good starting point in thinking about derivatives is to note that we all deal in them to some extent. A “derivative” is simply a contract whose value depends on the value of some other item. An insurance contract is a derivative of sorts. When you sign up for insurance, the insurance company makes money from you as long as the value of your car is maintained. If your car breaks and they have to pay out, then the contract becomes less valuable to them, but more valuable to you. Over time, you will probably pay out more in insurance than you get back, but you do it because you, as an individual, can’t afford to keep enough money aside to deal with sudden financial disasters.

From the insurance company’s point of view, their business makes sense for two reasons. Firstly they have money. If you total your car, they can afford to pay out. But more importantly they know, from their understanding of the car accident business, that only a small fraction of their customers will claim in any one year. If people were suddenly to start having lots more accidents, car insurance companies would be in trouble.

So here are some things to bear in mind about derivatives:

• They can be used to allow people to pay others to take on risk
• Valuing them involves knowledge of statistics
• If the basic assumptions on which your valuation rests change, you can be in big trouble

In any business that is supposedly about risk management, careful control of what you are doing is vital. A cautious company can do a lot of good with derivatives. For example, it could charge one company to insure it against a fall in the price of oil, and charge another company to insure it against a rise in the price of oil. Which ever way the price goes, our derivatives company makes money, and both clients get insurance, so everyone is happy.

Unfortunately it doesn’t always work like that. To start with, the sort of people who end up trading derivatives are also the sort of people who tend to be gamblers by nature. Unless you keep a close eye on them, they will make bets on the market. Many of the huge banking disasters that you hear about happened because one person made big bets, lost, and tried to cover his losses by making even bigger bets, all the while hiding what he was doing from his employers. Strict monitoring of trading, and measuring the risk to which your company is exposed, is therefore vital.

Then there is that whole assumptions thing. Market conditions can change. When I was doing derivatives training, one of the things I used to encourage companies to do is stress test their assumptions by looking to see what would happen if the market in which they operated changed significantly in certain key ways. Unfortunately senior managers often don’t like to look at disaster scenarios. They would much prefer to assume that everything will continue on as usual than spend money safeguarding against what appears to them to be a very small risk, even if that risk can lead to a very big disaster.

Finally there is the complexity issue. Some types of derivative are very easy to value. Others are not, and some have no mathematically proven valuation techniques at all. But the more complex a derivative is, the more interested greedy people are in selling it, because they figure that they can charge more for something that other people don’t understand. Except sometimes they don’t charge enough, because they didn’t understand it either.

Ideally, of course, you would regulate all of this potentially disastrous trading activity. But that assumes that you have regulators who understand the business and can form sensible regulations. And to a certain extent, if you regulate a bunch of common (and fairly safe) forms of derivative trading, that just encourages reckless companies to move into unregulated (and less safe) types of business. Inevitably also there will be a bunch of Libertarian economists on hand ready to attest that all regulation is wrong and no one should ever do it.

So we get situations like this, where a whole bunch of people who invested lots of money in merchant banks without ever understanding how those banks did business, are now complaining that they didn’t understand how risky their investments were. But you know, buying stocks is trading in derivatives too, because a stock is something that is dependent on the value of the company it is attached to. We all trade in derivatives, and we all need to remember that seemingly profitable investments normally get that way because they are risky.