Derivative Markets and Financial Risk

http://www.stanford.edu/~wfsharpe/art/fer/fer94.htm

Financial Economists Roundtable
Statement on Derivative Markets and Financial Risk
September 26, 1994

Observers recently have expressed heightened concern that derivatives may undermine the stability and efficiency of our financial markets and institutions. Firms increasingly are using forwards, futures, options and swaps, and various combinations of these fundamental derivative instruments both to manage or reduce risk and to increase returns. Current concern about derivatives centers on the expanding use of customized off-exchange (or OTC) derivative instruments, the largest component of which are interest rate and currency swaps. Although acknowledging that the growth of derivatives is a reflection of the market's demand for better instruments with which to manage risk, both the Congress and regulators remain uneasy about the misuse of derivative instruments and the potential consequences that might flow from a major default in derivatives markets. This concern, no doubt, partly stems from the sheer size of derivatives markets in general and to the ballooning OTC derivatives market in particular. The General Accounting Office (GAO) reports that at year-end 1992 the notional value of outstanding futures, forward, options and swap contracts alone totalled more than $17 trillion, up from $7 trillion in 1989. Another reason for concern about derivatives is the seemingly impenetrable complexity of some of these instruments. This complexity has created an aura of mystery about derivatives markets, and has fostered a fear that a miscalculation by someone, or an undetected but vital flaw in the market or regulatory system, could trigger failures cascading into a financial market meltdown. Several studies of OTC derivatives markets in the last few years by the Bank for International Settlements (the "Promisel" Report), the Bank of England, the Group of Thirty, the Office