|Cato Policy Analysis No. 283||September 11, 1997|
by Thomas F. Siems
Thomas F. Siems is a senior economist and policy adviser at the Federal Reserve Bank of Dallas. The views expressed here are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of Dallas or the Federal Reserve System.
In our fast-changing financial services industry, coercive regulations intended to restrict banks' activities will be unable to keep up with financial innovation. As the lines of demarcation between various types of financial service providers continues to blur, the bureaucratic leviathan responsible for reforming banking regulation must face the fact that fears about derivatives have proved unfounded. New regulations are unnecessary. Indeed, access to risk-management instruments should not be feared but, with caution, embraced to help firms manage the vicissitudes of the market.
In this paper 10 common misconceptions about financial derivatives are explored. Believing just one or two of the myths could lead one to advocate tighter legislation and regulatory measures designed to restrict derivative activities and market participants. A careful review of the risks and rewards derivatives offer, however, suggests that regulatory and legislative restrictions are not the answer. To blame organizational failures solely on derivatives is to miss the point. A better answer lies in greater reliance on market forces to control derivative-related risk taking.
Financial derivatives have changed the face of finance by creating new ways to understand, measure, and manage risks. Ultimately, financial derivatives should be considered part of any firm's risk-management strategy to ensure that value-enhancing investment opportunities are pursued. The freedom to manage risk effectively must not be taken away.
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