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Derivatives: Good for Risk Mitigation and Growth

As volatility in equity markets this year demonstrate, the world continues to be a risky place. Fast-moving changes in foreign exchange and commodity markets have real impacts on stock markets, business confidence and economies. These developments illustrate the continuing need for financial tools that can mitigate an escalation of the kind of uncertainty that can freeze investment and hiring plans. However, in the aftermath of the Great Recession, many people perceive derivatives in a negative light. Our research and others demonstrates how the use of derivatives can improve economic performance.

What are the sources of the confusion surrounding derivatives? First, most Americans, even many of the most affluent and financially sophisticated, have a hard time understanding the alphabet soup of terms, and can't differentiate financial products such as securitization of mortgages (MBS) and synthetic collateralized debt obligations (CDOs) from a derivative product--interest rate swaps (IRS). Second, many have confused the expansion of leverage in the financial system--the use of borrowed funds for making investments--and faulted derivatives for disruptions actually caused by over-leverage.

Many banks and non-financial firms use derivatives in the course of everyday business. In fact, investors generally use derivatives for three purposes: risk management, price discovery, and reducing transaction costs.

In traditional banking, a mismatch in maturities between assets and liabilities exposes banks to interest rate risk. But derivatives can mitigate this risk, and thus improve capital adequacy and profitability, while lowering the chances of bank failure. In addition, banks make markets in derivatives to meet the risk management needs of financial and non-financial firm customers. In the process, they generate fees and other revenue from this trading, as well as lower their cost of funding.

For non-financial firms, derivatives can help manage risk from cash flow volatility arising from adverse changes in interest rates, exchange rates and commodity and equity prices. The tax code also offers incentives for hedging cash-flow volatility and income. A hedging strategy involving derivatives can alleviate under-investment caused by insufficient cash flow and risk aversion. For example, in 2011, United calculated that every $1 increase in the price of a barrel of oil added $95 million in its operational costs. Airlines use futures to hedge against adverse price shifts, and prevent out-of-control costs from impacting consumers. Farmers use derivatives to lock in prices for crops and theme parks can employ these instruments to insure against rainy days and low attendance.

What has been lost in the drama over derivatives is an understanding of the positive impact these instruments have had on U.S. economic growth over the long term. The use of derivatives by banks and non-financial firms has an indirect but powerful impact on economic growth via several channels.
Our statistical analysis demonstrates that banks' use of derivatives allows for a larger volume of commercial and industrial loans, holding other factors constant, and increasing business investment. Additionally, it confirms that investors assign higher valuations to non-financial firms using derivative products, and those valuations boost their ability to grow and create jobs.

Banks' use of derivatives, by permitting greater extension of credit to the private sector, combined with the use of derivatives by non-financial firms, improving their ability to undertake capital investments, expanded U.S. real GDP by about $3.7 billion each quarter from 2003 to 2012.

• The total increase in economic activity was 1.1 percent ($149.5 billion) between 2003 and 2012.

• By the end of 2012, employment had been boosted in these years by 530,400 (0.6 percent) and industrial production 2.1 percent, due to the use of derivatives.

For all that derivatives do in contributing to economic growth, the opaque market structure in which OTC-related derivatives operated prior to the financial crisis, as well as their outright misuse by some, made significant regulatory changes necessary. These changes have focused largely on addressing a lack of transparency and an absence of capital and collateral requirements in OTC-related markets.

It's too soon to tell if the remedies put forth in legislation like Dodd-Frank will succeed, since many of the new features are still being implemented fully. While additional regulatory fine-tuning will be needed as the global financial system evolves, we should not cast aspersions on the entire asset class of derivatives because a small portion of them were misused. The good far outweighs the bad.

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