I read somewhere that derivatives are the biggest weapons of financial destruction. Why do we need derivatives? If exploiting risk-proneness of people to make profit is the goal, why don't we stop with stocks alone? Derivatives also entail complicated math for their pricing while stock prices are usually modelled as Brownian motion. Why do we go for such a dangerous complication? Is it possible to understand their necessity in simple terms?
closed as not constructive by Bob Jansen♦, vonjd, Matt, Joshua Ulrich, chrisaycock Dec 29 '12 at 20:01
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One of the largest misconceptions of derivatives is that they destroy wealth. In fact, derivatives cannot destroy wealth by their construction, rather, they merely transfer wealth from one party to another. This is because generally, derivatives are voluntary contracts between two parties, where one side's gain exactly matches the other's loss.
The utility of derivatives flows from their enabling investors to purchase insurance against adverse states of the world, or conversely, to allow investors the opportunity to earn a premium providing providing insurance to those who need it.
Part of what happened in the 2007-2008 financial crisis was certain financial institutions assumed the role of insurance providers, earning small premiums in exchange for bearing risk. They took this practice to an unsafe extreme as it seemed to generate large profits while times were good, at the same time creating risks far beyond what common sense would suggest. When times turned bad, the losses some institutions faced were crippling, causing turmoil in financial markets.
That social malady was not caused by derivatives, but rather poor risk management. Derivatives are simply financial technology, amazing tools when used appropriately, but are neither inherently good or bad. The research which should have prevented the financial crisis goes back decades to when Harry Markowitz first introduced the mathematical formalization of diversification. Even though it is obvious to most that one should not put all of their eggs in one basket, that does not mean everyone will act accordingly.