The derivatives market, which has found its way into some exchange traded funds (ETFs), has around $1.2 quadrillion under assets – a cardinal number represented as 1 followed by 15 zeros, and yes, it really is a number. And it could grow as big bank bonus policies push more traders into the derivatives market.

Paul Wilmott, a leading expert in derivatives who holds a doctorate in applied mathematics from Oxford University, calculates that the $1.2 quadrillion is the so-called “notional value” of the worldwide derivatives market, or 20 times that of the world economy, writes Peter Cohan for Daily Finance. [Derivatives-Based ETFs Await SEC Decision.]

Wilmott provides an example of the risks involved with over-the-counter “customized” derivatives to the financial world. Among the uses of derivatives that can have adverse effects include:

  • What Wilmott calls “positive and negative feedback loops.” Depending on the percentage decline in a particular index, investors would sell a fixed proportion of their portfolio, otherwise known as portfolio insurance. This could lead to a positive feedback loop, or a situation in which a stock price decline leads to more selling, which increases market volatility. However, there were no negative feedback loops to counteract the positive feedback loop – traders who would sell stocks as they rose and buy as they declined.
  • Traders are also more prone to follow the pack. For example, if one trader bets against the pack and knows how the market will turn, the lone trader may win a couple of million but the larger group would end up losing billions. By joining the herd, the lone trader would increase the odds of the whole group receiving a higher bonus at the end of the day.
  • Traders are also motivated by a fat bonus payday, so they increase risks by taking bigger bets and also assume the existence of trading profits before they are realized. Big bank compensation policies also engender behavior that would boost market volatility.

The SEC is looking into the use of derivatives in ETFs as we write. What it will ultimately mean is still up in the air, but in any case, traders should use ETFs that employ derivatives with care. They have important uses for traders who know what they’re doing, but they are not for everyone. [All About Leveraged and Inverse ETFs.]

For more information on ETFs, visit our ETF 101 category.

Max Chen contributed to this article.

Post Comment