Derivatives and the Financial Crisis
Briefing paper

Tessa M. James
Fred R. Becker, Jr

Econ 3090-002

The National Bureau of Economic Research (NBER) defines an economic recession as a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales." Most economists identify recessions when a country experiences two or more quarters of contraction in the economy. Prior to 2007, The GDP in the United States had averaged around 1% per quarter, but towards the ending of 2007 and the beginning of 2008, the United States hit a recession. Many factors were said to contribute to the Great Recession, derivatives playing a vital part.
Derivatives are a financial instrument with a value dependent on the value of some other, underlying asset and are legal agreements between two parties to trade an underlying asset at a date in the future. Derivatives have been traded for many years, going way back to the tulip bulb options in Holland and rice futures in Japan in the seventeenth century. Derivatives are mainly used to control risk called “hedging”, or to increase risk called “speculation” in order to enhance returns. A derivative makes it possible to take on riskier projects for a promised of higher returns.
The global financial crisis has been credited to sub-prime mortgage lending and mortgage backed securities, along with over the counter (OTC) derivatives; mortgage backed securities is a specific type of derivative. OTC derivatives is said to have played a large part in the financial crisis due to poor regulation, lack of transparency in the market, excessive leverage and failure to manage the risk. While the source of the financial crisis is presumed to have been the residential real-estate asset price bubble, the underlying systemic risk, lies in OTC derivatives. This paper will review Derivatives and how it contributed to the "perfect storm" which leads to the Great Recession along with some legislation and regulatory actions taken.
Introduction
A derivative is a special type of contract; common types are futures, options, forwards and swaps; that serve several functions within an economy. Risk management is the primary and most prominent use of derivative contracts. Derivatives are meant to cover risks, and are used to cover the impulses of price fluctuations. Speculative activity; where participants focus only on price movement in the market, helping to balance the market; when people follow the trend in the market, speculators help to bring prices back to equilibrium. Another crucial role of derivatives is price discovery; the present and future price of commodities or financial asset. Prices of stocks and commodities tend to move in the same direction as the expectations of market participants. The price in the futures market reveals the supply and demand expectation in the future which helps the process of price discovery in the spot market.
Accompanying derivatives, is the underlying systemic risk, which can have detrimental effects; a defaulting of one derivative contract can spreads to other contracts and markets, causes the financial system to be threatened. The financial crisis revealed how interrelated the global financial system really is. What started off as a real estate bubble stimulated by sub-prime mortgages, expanded into a global financial fluster and panic. After The Commodity Futures Trading Commission received a rejection to have the OTC derivatives markets regulated, there were early signs that there was vulnerability in the system, if the derivatives market would continue unregulated; the request should not have been taken so lightly. Derivative instruments were created after the 1970s to create insurance against downside of the market. They were created in response to the recent experience of the oil shock, high inflation and a 50% drop in the U.S. stock