Myths about Derivatives

Although my students already know that some of these are myths, it does not hurt to be reminded of them every once in a while. Here is a sampling of the first myth, that includes the story of Thales, one that I shared with my Derivatives class a couple of weeks ago:

Myth Number 1: Derivatives Are New, Complex, High-Tech Financial Products Created by Wall Street’s Rocket Scientists

A description of the first known options contract can be found in Aristotle’s writings. He tells the story of Thales, a poor philosopher from Miletus who developed a “financial device, which involves a principle of universal application.” [2] People reproved Thales, saying that his lack of wealth was proof that philosophy was a useless occupation and of no practical value. But Thales knew what he was doing and made plans to prove to others his wisdom and intellect.

Thales had great skill in forecasting and predicted that the olive harvest would be exceptionally good the next autumn. Confident in his prediction, he made agreements with area olive-press owners to deposit what little money he had with them to guarantee him exclusive use of their olive presses when the harvest was ready. Thales successfully negotiated low prices because the harvest was in the future and no one knew whether the harvest would be plentiful or pathetic and because the olive-press owners were willing to hedge against the possibility of a poor yield.

Aristotle’s story about Thales ends as one might guess: “When the harvest-time came, and many [presses] were wanted all at once and of a sudden, he let them out at any rate which he pleased, and made a quantity of money. Thus he showed the world that philosophers can easily be rich if they like, but that their ambition is of another sort.” [3] So Thales exercised the first known options contracts some 2,500 years ago. He was not obliged to exercise the options. If the olive harvest had not been good, Thales could have let the option contracts expire unused and limited his loss to the original price paid for the options. But as it turned out, a bumper crop came in, so Thales exercised the options and sold his claims on the olive presses at a high profit. [link]

Other myths:

Myth Number 4: Only Large Multinational Corporations and Large Banks Have a Purpose for Using Derivatives

Myth Number 7: Only Risk-Seeking Organizations Should Use Derivatives

Myth Number 10: Because of the Risks Associated with Derivatives, Banking Regulators Should Ban Their Use by Any Institution Covered by Federal Deposit Insurance

The article is from 1997, incidentally. And I got it via Newmark’s Door.

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1 comment for “Myths about Derivatives

  1. Chris Roldan
    October 25, 2011 at 4:02 pm

    Those interested in Myth Number 10 can check out the following link. It is FDIC research on credit derivatives.

    http://www.fdic.gov/bank/analytical/cfr/2011/wp2011/CFR_WP_2011_01.pdf

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