Theory, Culture & Society

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Theory, Culture & Society
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Derivatives: Virtual Values and Real Risks
Jakob Arnoldi
Theory Culture Society 2004; 21; 23
DOI: 10.1177/0263276404047414
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Derivatives
Virtual Values and Real Risks
Jakob Arnoldi
D
ERIVATIVES, ONE quip goes, ‘are too complicated to explain but
too important to ignore’ (Jorion, 1995: 4). Today derivatives are not
only an integral part of the global financial system, but also in many
respects the technological motor in the development and expansion of that
global financial system, and they themselves constitute markets of an almost
unfathomable size. At the same time, derivatives are often vilified both
inside and outside the financial system. Derivatives are frequently thought
to have caused (or to have partly caused) a range of financial defaults and
market disruptions, such as the 1992 EMS crisis, the 1994 bond market
crises, the 1995 dollar crisis, the Asian Crisis, the Mexican Crisis, the (de
facto) defaults of Metallgesellschaft, of Barings, of LTCM, the fiscal crisis
of Orange Country.... The list is long, though it often is debatable whether
or not derivatives in each case were the main culprits or the culprits at all
(see e.g. de Goede, 2001; MacKenzie, 2003b for two highly diverging
accounts of the role of derivatives in the crash of LTCM).
The (sparse) sociological literature on derivatives often emphasizes the
strangely imaginary (Lee and LiPuma, 2002; Pryke and Allen, 2000) or
virtual character of derivatives. Derivatives are, so to speak, assets based
on nothing, values created out of thin air (thus both confirming and expand-
ing Simmel’s classic deliberations on the phenomena of money and value).
Moreover, derivatives are in the (very few) sociological accounts of deriva-
tives markets that do exist, often framed by a narrative of risk and uncer-
tain futures (e.g. Adam, 2003; de Goede, 2001). The article will try to
theorize derivatives by combining the notion of virtuality with the notions
of risk and future uncertainty. The heart of the argument will be that deriva-
tives, as a technology, do not simply create risks or future uncertainties but
in fact also use such uncertainties as a resource. Derivatives use uncer-
tainty by virtualizing it.
(cid:1)
Theory, Culture & Society2004 (SAGE, London, Thousand Oaks and New Delhi),
Vol. 21(6): 23–42
DOI: 10.1177/0263276404047414
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24 Theory, Culture & Society 21(6)
The article will unfold this argument, and its implications, in four
ways. First, it will show how the financial technology of derivatives is based
on new probabilistic and non-linear forms of scientific knowledge that make
it possible to envisage and meaningfully ‘model’ the future. That is to say
that the future becomes an object of knowledge, something that, through
computer modelling and advanced forms of probabilistic calculations,
comes to inform our present and becomes a basis for action, technologies
and, ultimately, in the present case, financial assets. Derivatives, we shall
see, derive their value from calculations of possible future changes to the
value of their underlying assets (this is of course calculations of risk). Thus,
the future ceases to be something that is merely possible – and hence non-
existent – and instead becomes something that – even though it strictly
speaking remains non-existent – has being ‘in practice’. When something
comes to exist ‘in practice’, but not in reality in the strict sense, it can be
said to be virtual. Hence, we shall later talk about derivatives as virtual
assets or virtual goods.
Second, such calculations, which render the future not only possible
but also virtual, can only be achieved by means of information technolo-
gies. Virtuality has, for good reasons, come to be associated with computer
technology and other new forms of information and communication tech-
nologies (ICT). Derivatives are no exception. It is only thanks to new
computer technology that derivatives can be constructed and sold for even
remotely correct prices (Aglietta and Breton, 2001: 436; Braddock, 1997:
v). As such, derivatives as a technology and derivatives markets as
economic institutions are typical of the information age (Castells, 2000a,
2000b). However, the crucial thing about derivatives is not information tech-
nology but the fact that derivatives are an informational technology
(Castells, 2000b: 70, 100). By means of specific forms of knowledge, future
risks can be processed as information.
Third, derivatives are financial assets derived from (the futures of)
financial assets. As such, they are strangely self-referential. Their usage
seems to support the argument, most prominently put forward by Hardt and
Negri (2000: 272), that capitalism, when it no longer is able to generate
value from material assets, as these have been exhausted, then starts to
generate value out of itself. In order to do so, Hardt and Negri note, capi-
talism is however still forced to use one resource, namely the future (2000:
272). They are primarily referring to the risks that future generations are to
inherit from the present one. But also derivatives are examples of the future
becoming a resource.
Fourth, the article will try to make some adjustments to the framing
of derivatives by means of notions of risk and reflexivity. Such accounts very
often construct a distinction between, on the one hand, rational, linear,
determinist (and, by implication, reductionist) science and, on the other,
reflexive, non-linear, indeterminist layman’s, life-world, or sub-political
forms of knowledge. The former creates risks but is blind to them, only the
latter can conceptualize these risks. The article will argue, however, that
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Arnoldi– Derivatives 25
the knowledge base for the technology of derivatives is characterized
precisely by its ability to conceptualize risks and contingent futures. Hence
the just mentioned distinction is somewhat muddled. Derivatives are both
products of an increased awareness of the risks and contingencies of the
future and of technological attempts to ‘tame’ these contingencies. Indeed,
it seems that derivatives are just one example of an increasingly occurring,
and highly paradoxical, phenomenon: the more indeterministic, contingent
and even uncertain (and, as we shall see, virtual) scientific knowledge
becomes, the bigger its influence on the world through the development of
new technologies (Nowotny et al., 2001: 185) – which again creates new
uncertainties.
The article will conceive of derivatives as (high) technological finan-
cial products. What follows is therefore as much a study of technology as it
is a study of finance and economics. Derivatives are, paraphrasing Castells
(2000b: 29), informational technological products that are created through
the application of knowledge and information to other information. Before
attempting to unfold the hypotheses just outlined, the article will describe
the ‘case’ in point, namely the technology of derivatives and the markets of
derivatives trading.
A Brief Description of Various Types of Derivatives
Derivatives, as the name suggests, are financial commodities whose values
are derived from the value of underlying assets (Hull, 2003: 1). In nearly
all forms this involves time and the future. The most basic type of deriva-
tive, a forward, is a contract that specifies delivery of an (underlying) asset
at a given point in the future. Derivatives are traditionally defined as instru-
ments that insure against, or transfer, market risks. They do so – with the
exception of swaps – by guaranteeing a certain future price of the asset in
question. Yet, such instruments also offer leverage and are therefore attract-
ive to speculators. ‘Leverage’ refers to the fact that the price of a derivative
is only a fraction of the price of the underlying asset while the possible
profit, or loss, of a derivative acquisition may equal the profit or loss of
speculating in the underlying asset. Derivatives make it possible to buy the
risk of possessing an asset without buying the asset itself. Hence bigger
profits, or bigger losses, can be generated from a smaller initial investment.
But while derivatives often are used for highly leveraged (long) positions,
they are at the same time instruments for management, transfer and control
of financial risk. Just as one can buy the risk of possessing an underlying
asset, so one can also sell the risk of possessing an asset. That also means
that even high-risk (long) positions in the market can be hedged by a deriva-
tives portfolio, which indeed they most often are. By so doing, the risk of a
long position is transferred to another party.
Whether or not derivatives are used for hedging or for taking lever-
aged long positions, the core feature of derivatives trading remains the same,
namely the transfer, or trading, of the risks caused by possible fluctuations
of the market value of the underlying asset. And the substance which forms
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26 Theory, Culture & Society 21(6)
the economic value of derivatives is the risk or the uncertainty of future
fluctuations of the market value of the underlying assets. As Bernstein has
formulated it (Bernstein, 1996: 314) ‘the product in derivative transactions
is uncertainty itself’. It is this highly immaterial and virtual aspect of deriva-
tives that is to be the central focus of this article. Derivatives markets trade
future uncertainties: possible futures become traded, become financial
goods, and thus come to have being in practice.
Derivatives can be either standardized products, which are traded in
exchanges, or tailor-made (structured) products, which typically are sold by
a bank to a client ‘over-the-counter’ (OTC). The four major forms of deriva-
tives are forwards, swaps, futures and options (their characteristics will be
explained below), of which some are exchange traded, some OTC products
and some both. A forward contract is the simplest type of derivative. It is a
transaction between two agents involving the buying or selling of a specific
commodity at a specific future point of time. The agent who buys the forward
thus agrees to buy a product at a given point of time. Most forwards contracts
are entered into by a bank and one of its customers. One of the biggest
markets in forwards is in currencies. Futures are standardized forwards,
which means they can be exchange traded. The underlying assets can be
anything from pork bellies, to currencies, to stock market indexes.
Commodity futures have been exchange traded in Chicago since the mid
1850s (Hull, 2003: 1), while currency futures were introduced in 1972 and
bond futures in 1976 (Leslie and Wyatt, 1992: 88). Both innovations were
made in Chicago, which today is the global centre for derivatives markets.
But futures are today traded in nearly all financial markets. The biggest
European market is located in London. An optiongives the holder the right
to either buy (call option) or sell (put option) the underlying asset either at
the expiry date (European options) or within a given period (American
options). Options on financial assets were also invented in Chicago, where
the first organized market in call options on stocks started in 1973, followed
by put options in 1977 (Hull, 2003: 2). As is the case with futures, options
are today traded over most of the world. Unlike futures, options are also
traded over-the-counter. Swapsare much more recent financial instruments
that have only been traded on a large scale since the 1980s (Bonetti and
Cobham, 1992: 13). Generally, swaps are agreements to exchange money
flows. An interest rate swap is an agreement to exchange, or swap, interest
payments on loans (most often a floating rate and a fixed rate loan) but not
the principals of the loans. Currency swaps are similar, except that here
both the interest payments and the down payments on the loan of the
currency are included.
As mentioned, these four basic types of derivatives can be endlessly
recombined, especially as OTC products. So there also exist such things as
swaptions (a combination of options and swaps) and compound options
(options on options). Many derivatives are synthetic structures, as they
synthesize different assets. And many financial products embed derivatives.
A given financial product may thus be a combination of, say, a bond and an
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Arnoldi– Derivatives 27
option. Many of these are credit derivatives, such as structured notes (e.g.
floating rate notes which have a fixed market value but a fluctuating coupon
– bonds of course have a fixed coupon but their market value fluctuates
according to the interest rate adjustments) and repos; repos can also be
classified as derivatives since their value is partly derived from an under-
lying asset and because also they can be used for both hedging and specu-
lation.
‘Derivatives’ are thus a denominator for a highly heterogeneous set of
financial products. They are often also called structured products because
they have been engineered with specific objectives in mind. In particular,
the last 15 years have seen innovations in the form of a vast array of new
derivatives, engineered for specific purposes and or/based on a variety of
underlying assets. This process of innovation and development seems to be
ongoing, creating new markets and expanding the scope and volume of the
global financial system (it is no coincidence that Castells [2000b: 258]
mentions derivatives as an example of the key role of innovation in the infor-
mational economy). The key features remain, however, that they all in effect
transfer risks based on future developments from one agent to another, that
they thus can be used to hedge risk, and that they offer leverage in the sense
that an aggressive speculator can afford a bigger risk with a smaller invest-
ment. Only futures and options are traded on exchanges while the rest are
traded over-the-counter. As such, they frequently escape both audits and
regulations, a fact which in itself causes risks and uncertainties. Lastly, and
most significantly, the different hybrid products are often immensely
complex. Their value, and the portfolio risks they pose, are therefore often
extremely difficult to calculate. Both forwards and futures have existed in
Europe since the 17th century and have been used to guarantee or insure
against unforeseen events that might affect prices of a commodity. However,
while such contracts have existed for a long time, it is only within the last
30 years that derivatives trading has really taken off. I will return to why
that is shortly.
History, Volume of Trade and Underlying Assets
Although derivatives can be said to have existed for 4000 years (Swan,
2000: 28) and have existed in their present sophisticated form since the
16th century – even then they caused market crashes, like the ‘Tulipmania’
in the Netherlands in the 1630s1– their use has increased dramatically over
the last 30 years. Derivatives have been by far the most successful finan-
cial innovation within the last three decades, creating new high-liquidity
markets of truly staggering dimensions. In many ways this new phase of
derivatives trading dates back to the opening of the new derivatives
exchanges in Chicago in 1972 and 1973, and the publication of the so-
called Black–Scholes model in 1973. This equation made it possible to
calculate the price of options based on assessments of the (future) volatil-
ity of the underlying asset. But other factors must also be mentioned, such
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28 Theory, Culture & Society 21(6)
as the increased volatility of the post-Bretton Woods financial systems and
new information technology. I will return to all these aspects below.
There are different ways of measuring the volume of the market and
conflicting data sources. But there are sufficient data to show both the vast
size of the markets and their rapid growth. The volume of the exchange-
traded market is often measured either as turnover or as notional amount
outstanding, while OTC derivative market activity normally is measured
only as notional amount outstanding. To get a sense of the size of the figures
about to be presented, it may be helpful to know that the annualworld GDP
in 2000 was approximately $147 trillion. In contrast, the combined turnover
of (only) exchange-traded derivatives in the first quarter of 2003 was $197
trillion (Jeanneau, 2003). In 1997, the combined annual turnover of OTC
and exchange-traded derivatives was estimated to be $675 trillion (Schinasi
et al., 2000: 9). Even though the increase in the volume of derivatives
trading was to some extent instigated by the opening of the derivatives
exchanges in Chicago, it is within the OTC sector that the real growth has
occurred in the last 10 years. The volume of OTC market activity can truly
be said to have exploded (see Figure 1), and has far surpassed the volume
of exchange-traded activity. In June of 2000, the notional principal for
exchange-traded derivatives stood at $13.9 trillion while for OTC deriva-
tives it was $94 trillion (Schinasi et al., 2000: 9). The market for OTC
derivatives has continued to grow. In the last half of 2002, the notional value
of OTC derivatives stood at almost $142 trillion (Jeanneau, 2003: 32).
Derivatives are the world’s biggest business.
As for the growth, Figure 1 gives an overview of the growth of OTC
activity. The data are from the International Swaps and Derivatives Associ-
ation, which is the only body that has surveyed the derivatives markets for
a longer stretch of time. The Bank for International Settlements (BIS) has
surveyed the market since 1997 and its data estimate the OTC market to
be almost twice as big (the $147 trillion figure given above is from BIS). An
indication of the relationship between exchange and OTC activity can be
gleaned from the fact that they were approximately the same size in 1987
(Schinasi et al., 2000: 12).
It is not only in volume that derivatives markets have grown, however.
The explosive growth of OTC derivatives has resulted both in an endless
list of recombinations of the four main types and also in an astonishing
diversity of assets underlying derivatives. Weather derivatives are one
example. A Japanese producer of throat lozenges is thus able to buy weather
derivatives from Hiroshima Bank, a specialist in this product, to avoid the
risk of slow sales during periods of weather that are not favourable for the
sale of the company’s product (The Economist, 2002). Another underlying
asset for derivatives is sulphur dioxide emission quotas, which have been
traded in the USA since the early 1990s. The now-defunct energy company
Enron used to be the leading player in the development of these derivatives
and stood – had the American President decided to ratify the Kyoto Protocol
– to be the leading player in the development of a global carbon
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Arnoldi– Derivatives 29
OTC interest rate and currency swaps and options
120,000
100,000
80,000
$
S
U
ns 60,000
o
Billi
40,000
20,000
0
2h87 2h88 2h89 2h90 2h91 2h92 2h93 2h94 2h95 2h96 2h97 2h98 2h99 2h00 2h01 2h02
Half-year (July–Dec.) notional amounts outstanding
Figure 1 Global trade of OTC derivatives 1987–2002.
Source: International Swaps and Derivatives Association, Inc. (www.isda.org)
dioxide-emission derivatives market. This derivatives market could very
well have become one of the biggest markets (of any kind) ever (MacKenzie,
2003a: 6) and would probably have saved Enron from bankruptcy.
The (Derivatives-created) Demand for Derivatives
But why the enormous success of this high-tech financial product? Theor-
izing derivatives of course also entails speculating about the causes for the
innovation of derivatives. Let me begin by quickly outlining some general
explanations for the success of derivatives, explanations about which there
is general consensus in the literature. As with most explanations for the
innovation of technology, these explanations need to strike a balance
between market demands (and other physical, political, economic and social
conditions that render the implementation of the technology feasible and
desirable) and developments in scientific knowledge that form the basis for
the innovation. Hunt and Kennedy (2000: 1) give the following two expla-
nations, which resonate with most other analyses found in the literature.
1. More volatile financial markets have created a market demand for finan-
cial products that enable investors to reduce their risk exposure and
enable banks to hedge the risks of the products they sell their customers.
One might add that more globalized financial markets also create a
demand for financial products that enable economic agents to enter far-
away markets. For that purpose, swaps are useful tools.
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30 Theory, Culture & Society 21(6)
2. Developments in theories of probability have led to the creation of
increasingly sophisticated forms of derivatives that are more accurately
priced. It has become easier to measure risk and thus also to give it
economic value. This development was in many ways instigated by the
invention of the Black–Scholes model in the early 1970s.
To Hunt and Kennedy’s two explanations we need to add a third, although
perhaps a slightly more marginal one; namely, new information technolo-
gies. Both the trading of derivatives and especially the computation of the
prices of derivatives rely heavily on new information technologies (Aglietta
and Breton, 2001: 436). Bernstein (1996: 316) points out that the
Black–Scholes model was published at exactly the same time that Texas
Instruments put their new hand-held electronic calculator on the market.
Today’s extremely complex calculations of derivatives would often not be
possible were it not for advanced computers. Indeed, advances in proba-
bility theory itself (outside the context of financial theory) would probably
not have been possible without computer power. So these two aspects are
closely intertwined. This is yet another reason for using the notion of virtu-
ality as virtuality both signifies an ability to conceptualize the future to such
an extent that it becomes given ‘in practice’ (probability) and refers to
computer-generated models of reality (ICT), the point being that in practice
these two things tend to cohere. Nevertheless, Hunt and Kennedy have a
point in emphasizing not computing technologies but the development of
the theories that are the basis for what is being computed. The important
thing is knowledge that makes it possible to conceptualize and opera-
tionalize possible future risks.
Of the two major explanations, the one regarding market demand due
to the volatility of the modern financial world is the most well known, so
there is little need for a detailed account (see Castells, 2000b: 101–6,
135–47; Pryke and Allen, 2000). The (final) collapse of the Bretton Woods
agreement in 1971 marked the beginning of a new financial era dominated
by a volatile global financial system that has spawned new uncertainties. It
is a global system that is highly interconnected (networked) and integrated
because of the innovation and implementation of information technologies,
which make it possible to transcend time and space, and a political process
of financial deregulation that has freed the global markets from earlier
constraints. Overall, this development has led to a market dominated by
speculation and by aggressive new players such as hedge funds, and which
generally is characterized by ‘a culture of risk taking’ (Pryke and Allen,
2000: 268; see also Comaroff and Comaroff, 2000: 296–8; Reith, 1999: 1).
Such a market of course creates demand for technologies that can ‘reduce’
risk. But also, we might add, it creates a demand for financial instruments
such as derivatives, which offer leverage. Hedge funds have very often used
derivatives for highly leveraged, and thus aggressive, forms of speculation.
Significantly, derivatives cater for both of these two demands.
The post-Bretton Woods world of finance has not merely created the
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Arnoldi– Derivatives 31
demand that derivative technologies cater for, the increased use of deriva-
tives has itself created new forms of volatility and risk. One reason for this
is simply that derivatives are not only useful tools for hedging but also for
speculation (Carter, 1989). Because they offer leverage, it is possible to
make a huge profit, or suffer a correspondingly huge loss, from a relatively
small investment. Another reason is that derivatives tend to link together
markets across spatial distances. Many OTC derivatives are synthetic
products (Tavakoli, 2001) in the sense that their value is based on a combi-
nation of different underlying assets. Swaps, for instance, create new links
between the different national currencies or interest rates that underlie
assets. Derivatives thus create new forms of complex interlinkages between
different markets, assets and actors, with a complex variety of possible
repercussions and spill-over effects and with very little transparency in
regard to the possible risks caused by these interlinkages. Hence, the
systemic risk is increased (Aglietta, 1996; Castells, 2000b: 104–5; de
Goede, 2001; Kelly, 1995: 220; Kregel, 1998; but see also Darby, 1994 for
a counter-argument). Or, more precisely put, derivatives transfer market
risks into a combination of market, credit and operational (or system) risks
(Aglietta and Breton, 2001: 439; Schinasi et al., 2000: 42). These new
uncertainties spread to other parts of the financial market, as well as to the
markets for the underlying assets of the derivatives. Turmoil in the under-
lying markets may in turn reverberate back to the derivatives market. This
factor is amplified by the simple fact that the sheer volume of the deriva-
tives market today means that if one of the big financial players develops
liquidity problems, this can cause market disruptions (Schinasi et al., 2000:
48). Or perhaps it is more accurate to say that the mere fear that one of the
big players might not be able to pay collateral could spark a crisis of trust
that in itself can cripple the OTC markets. MacKenzie (2003b) has argued
that this was indeed one of the main reasons for the (de facto) collapse of
the hedge fund LTCM in 1998, which caused widespread panic on Wall
Street.
Moreover, the complexity also creates new forms of non-transparency.
Buyers of derivatives do not necessarily fully understand what it is they are
buying (Kregel, 1998: 6). Some of the most famous cases of ill-fated deriva-
tives investments, such as the Procter & Gamble case, were simply caused
by senior management not fully understanding the implications of their
acquisitions. Another consequence of the immense complexity of deriva-
tives is that auditing and regulation are made difficult. The complex and
embedded nature of derivatives means that many market positions in (OTC)
derivatives can be classified as off-balance sheet and escape audits and
regulations (Carter, 1989: 784; Kregel, 1998: 6–16). Several forms of deriva-
tives, especially structured notes, are in fact specifically designed to
circumvent international currency regulations (Schinasi et al., 2000: 15).
To sum up, the role of derivatives as risk hedging tools is rather
ambiguous. Derivatives are useful tools for risk hedging but have also, at
least to some extent, created new risks. And certainly derivatives are not
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