So the underlying principle of derivatives is to create a market that includes many different viewpoints with counter parties that think differently from one another. This creates checks and balances and curbs groupthink that we have seen some market participants succumb to. This collective illusion has, in the past, led to several severe market crashes as noted in an earlier video on turbulence. In fact, the story of the 2008 financial crisis is one that takes place in the Swap markets, popularized in the best-selling book and Hollywood movie The Big Short. Now if you haven't seen this film you can check out this brief YouTube video to help you understand what exactly happened. The story centers around the hedge fund manager Michael Burry who did not take the expected route that many other hedge fund managers take. And that is by credit default swaps, or CDS, which we described earlier, to reduce risk, since he didn't have any loans to insure. Instead what Michael did was to invest in a ton of swaps by betting on a negative event or a market crash. Specifically, he predicted that derivatives made up of American home mortgages called collateralized debt obligations or CDO's, would lose value because they were being sold as safe investments. When in fact, they were extremely risky. His information was based on the fact that the mortgages underlying these derivative packages, were being sold a mus" to people who did not have the capacity to make the payments on their mortgages. Which is what the term sub-prime means. This resulted in a rash of home foreclosures and a collapse in the housing market, that eventually made the CDO investments worthless forcing major wall street investment banks, like Beston, Goldman sacks. And huge insurance companies like AIG, The American international Group, the default protection insurer, to pay over hundreds of billions of dollars. And since derivative instruments do not appear in the financial statements of banks, learning about their widespread use in the financial industry for speculative purposes that brought the global financial system to the brink of collapse gives pause to rethink. How policy makers can insulate the economy from the delitary effects. This kind of episode spooks investors and policy makers to this day as they try to find new ways to regulate and contain the size and volatility of global derivative markets. A history of turbulence however cannot dismiss that options, forwards, futures and swaps served the very important purpose of reducing risk for market participants by ensuring against future price movements. This is because, as we've already learned at the beginning of this discussion on derivatives, for a relatively small premium, paid to purchase the derivative. The future cost or price is being determined right now. For example if one party is a supplier or producer, the agreed upon future price finances this parties production. Where the party that will actually use the underlying commodity, security, or asset. The supply is assured, especially if the transaction occurs through an organized derivatives exchange where delivery is guaranteed. Derivative markets, therefore, offer very real benefits. This, rather than the allure of speculation, is what primarily explains the growth. In particular, derivative contracts have satisfied an enormous need to hedge and reduce risk. However, many analysts and policy makers are concerned about how financial markets have unraveled due to cases of systemic manipulation in a particular sector. The size of the derivatives market is also worth mentioning. The Economist magazine estimated a value of $700 trillion not long ago, which included the value of the underlying commodities, securities, and assets. Yet, the value of everything produced in the real economy, or the global GDP Is only one-tenth of that amount. Even if we measure how much money would change hands if derivative contracts were sold on the reporting date at prevailing prices or using gross market values, these are still in the trillions of dollars. And it's not just the enormous size of derivative markets that can be concerning. But also, that the majority of them are unsupervised, unreported and under regulated. What we call over the counter contracts, which are sold outside organized exchanges. The extremely complex structure of these instruments also leaves the best financial and economic experts scratching their heads which, by itself, is troubling. Some have also placed blame on governments. Subsidizing of derivative markets because the banks and the insurance companies intermediate in these transactions are now too big to fail. Ultimately, if taxpayers keep bailing out the financial industry, it lowers the cost for the latter. Since it enables them to take on risks, that they otherwise would not have done so. Either way, derivatives are not going away. Let's end on the same note as we started in this course. Markets have not only worked as time machines, which take society's savings into the future, to create economic growth. Wealth and prosperity. But as we have seen in this segment, they offer mechanisms to cushion us from the destruction caused by disasters through financial contracts and through insurance. This helps us to restart, to rebuild, and to reinvent. Hedging and reducing risk through things like derivative markets provide that critical function. Which, along with speculation, should be encouraged. The caveat is to come up with more visible transparent processes and counter-measures that can absorb shocks and sector failures. And hopefully prevent the kind of dangerous instability that led to the 2008 global financial crisis.
