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MYTHS ABOUT DERIVATIVES

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However, what seems to be a real problem is that many people (including many ... If you just stand there and do nothing, chances are, you are speculating unwittingly. ... – PowerPoint PPT presentation

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Title: MYTHS ABOUT DERIVATIVES


1
MYTHS ABOUT DERIVATIVES from myths to
truths S. J. Chang, Ph.D. College of
Business Illinois State University
2
Myths about Derivatives Despite the continuous
development and expansion in derivatives products
and their markets over the recent years, publics
perception toward derivatives in general still
appears to be rather unfriendly, uncomfortable,
or even negative. There is no doubt that a series
of derivatives-related mishaps over the years
have greatly contributed to people's such ill
feelings against derivatives. However, what
seems to be a real problem is that many people
(including many students, investors, corporate
managers, and even some investment professionals
and professors) actually do not understand what
derivatives really are. Specifically, people
seem to have the following misconceptions about
derivatives.
3
1. Derivatives are hard to understand. It
requires high-level knowledge (particularly math)
to understand derivatives. Any theory,
principle, or model that cannot be understood
with plain common sense and intuition is of no
great use. 2. Derivatives are all speculation,
have no economic value, and have nothing to offer
for rational, sound investors and corporate
managers. Through hedging, dynamic investing,
price discovery, and efficiency enhancement,
derivatives expand the market and bring every
economic unit closer to a complete market. 3.
Derivatives markets are not functioning properly
and hedging does not work. They are of no use
for corporate risk management. Perfect hedging
is impossible. However, through close hedging
and cross-market arbitrage, we can minimize
inefficient pricing in both spot and
derivatives markets.
4
4. Derivatives markets are not very efficient
and too volatile because of frequent speculative
trading. Frequent trading is induced by
volatility in spot markets. It does not
necessarily mean volatility in derivatives
markets, but it does provide liquidity, the
lifeblood for derivatives. 5. Derivatives are
very risky. To stay away from risk, do nothing.
Stay away from derivatives. If you just stand
there and do nothing, chances are, you are
speculating unwittingly. 6. Derivatives are
only for institutional traders, not meant for
individual investors. The need for hedging and
the incentive for active investing exist
equally for individuals and institutions.
Besides, it is individual traders who often
bring much needed liquidity to derivatives
markets. 7. Derivatives should be more tightly
regulated. As always, tight regulation will
dampen liquidity, efficiency, and innovation.
Derivative needs arise naturally.
5
Apparently, these points are interrelated and
quite possibly one implies next. In fact, they
all stem from essentially one fundamental
problem, that is, lack of correct, complete,
conceptual understanding of derivatives.
Considering the growing significance of the
economic functions and roles played by
derivatives, we should exert more efforts to
rectify such myths and misconceptions.
Particularly, students majoring in finance and
insurance should have a firm understanding of
derivatives markets and products before they
graduate. Derivatives Dynamic, versatile risk
management mechanism Dynamic,
versatile investing vehicle
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