RISKYINNOVATION:DERIVATIVESExcerptfromJosephStiglitz‘Freefall’Thefinancialmarketswereinnovative,butnotalwaysinwaysthatledtoamorestableandproductiveeconomy.Theyhadincentivestocreatecomplexandnon-transparentproducts,suchascollateralizeddebtinstruments(CDOs),slicinganddicingthemortgagesintosecurities,andthenslicinganddicingthesecuritiesintoevermorecomplicatedproducts.Whengambling–speculating-oncorn,gold,oil,orporkbelliesdidn’tproductiveenoughopportunitiesforrisk-taking,theyinvented“synthetic”products,derivativesbasedonthesecommodities.Then,inaflurryofmetaphysicalingenuity,theyinventedsyntheticproductswerehelpingtheeconomytomanagemeaningfulriskswell,butitwasclearthattheyprovidednewopportunitiesforrisk-takingandforearningheftyfees.Thesederivativesareamongtheinnovationsthatthoseinfinancialmarketsaremostproudof.Thenamesaysmuchabouttheiressence:theirvalueisderivedfromsomeotherasset.AbetthatthepriceofastockwillbegreaterthantendollarsnextMondayisaderivative.AbetthatthemarketvalueofabetthatastockwillbegreaterthantendollarsnextMondayisaderivativebasedonaderivative,.Thereareaninfinitenumberofsuchproductsthatonecouldinvent.Derivativesareadouble-edgedsword.Ontheonehand,theycanbeusedtomanagerisk.IfsouthwestAirlinesworriedabouttherisingpricemarket,lockinginapricetodayforoiltobedeliveredinsicmonths.Usingderivatives,Southwestcansimilarlytakeoutan“insurancepolicy”againsttheriskthatthepricewillrise.Thetransactioncostsmaybeslightlylowerthanintheolewayofhedging,say,buyingorsellingoilinfuturesmarkets.Ontheotherhand,asWarrenBuffetpointedout,derivativescanalsobefinancialweaponsfmassdestruction,whichiswhattheyturnedouttobeforAIG,astheydestroyeditandmuchoftheeconomyatthesametime.AIGsole“insurance”againstthecollapseofotherbanks,aparticularkindofderivativecalledacreditdefaultswap.Insurancecanbeaveryprofitablebusiness,solongastheinsurerdoesn’thavetopayouttoooften.Itcanbeespeciallyprofitableintheshortruntheinsurerrakesinpremiums,andsolongastheinsuredeventdoesn’toccur,everythinglooksrosy.AI