In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.
—Warren Buffett, letter to shareholders, 2002
Derivatives have often been characterized as dangerous tools of financial speculation, invented by mathematicians who are out of touch with reality, then sold by unscrupulous salesmen to gullible customers who do not understand the risks they are taking. They have been blamed for most periods of modern financial turmoil, including the 1987 crash, the bankruptcy of Barings Bank, the meltdown of Long Term Capital Management, and the current “subprime crisis.” Like many populist misconceptions, there are germs of truth in this straw man, but the full truth is far more nuanced, complex, interesting, and profitable to those who understand.
Derivatives are as old as recorded history. The first reference we have to derivatives is in Genesis 29. Jacob entered an agreement that obligated him to work for seven years in exchange for the hand of Rachel. However, after Jacob had fulfilled his part of the contract, Rachel’s father, Laban, defaulted on his obligations and made Jacob instead marry his elder daughter, Leah. So Jacob entered another agreement in which he again worked for seven years in order to marry Rachel.
• This was a forward agreement where Jacob paid (in labor) in return for something (Rachel) to be delivered at a certain time in the future for something (Rachel) to be ...