Microsoft has now issued a Security Advisory (977981) about the Internet Explorer vulnerability I mentioned yesterday. The advisory does not supply a patch for the flaw, or a projected timetable for a patch. It does, however, provide some suggested mitigation techniques.
Recently, The Economist had a briefing article on the financial derivatives markets and the challenges involved in regulating them appropriately. The issue has, of course, been brought to the fore by the recent crash in the financial sector, in which excessively risky derivative positions played a large part. (I have previously written about some of this in a series of posts: “Formulas for Disaster, Parts 1, 2, 3, and 4“.) The Economist article is well worth reading, and I will be writing, in a later segment of this article, about some of its recommendations. But first I want to talk a bit about some of the institutional aspects of the derivatives markets; they vary considerably among those markets with respect to some key characteristics, and I think understanding some of those variations is crucial to understanding why derivatives became such a problem.
As the article points out, derivatives have been around for a long time:
Derivatives have a long history, stretching back thousands of years. In the 17th century the Japanese traded simple rice futures in Osaka and the Dutch bought and sold derivatives in Amsterdam.
Derivatives, as their name suggests, derive their value by reference to another asset or financial indicator (sometimes called the underlying asset, or simply the underlying). A relatively simple example is an option on a traded common stock. A (hypothetical) three-month call option on Microsoft at $20.00 would give the holder the right, but not the obligation, to buy a specified quantity (typically, 100 shares) of Microsoft stock at any time within the next three months. If the option was not exercised by then, it would expire. Clearly, the value of this option would depend on the price of Microsoft stock. If it were $40 per share today, one could exercise the option, buy 100 shares for $2,000, and then immediately sell them for $4,000, making a tidy profit. If the price were $10 per share today, the options would probably not be worth very much.
Another simple example is given by contracts in commodity futures. Essentially, these are purchase contracts for a given quantity of a physical commodity (such as crude oil, wheat, or pork bellies) for delivery at a specified future date at a specified price. Such contracts might be used, for example, to “lock in” a price for a portion of his wheat crop in advance of the harvest.
These simple types of derivative contracts are fairly benign, for reasons which we’ll explore in a moment, but even they have been accused of enabling all kinds of mischief, as the article points out:
In 1958 American onion farmers, blaming speculators for the volatility of their crops’ prices, lobbied a congressman from Michigan named Gerald Ford to ban trading in onion futures. Supported by the president-to-be, they got their way. Onion futures have been prohibited ever since.
It is easy to cite examples like this one to give the impression that worry about derivatives is often silly. After all, no one has ever blamed a major financial panic on fluctuations in the price of onions (although the Dutch did get into it with tulip bulbs).
I would agree that worrying about things like onion futures, or options on Microsoft stock, is foolish if one’s concern is the overall stability of financial markets. But I would like to note that derivatives like these (commodity futures, traded options, and similar contracts) have some common characteristics, which I will argue are of substantial significance:
- The underlying assets are traded in an open and public market, in which transaction prices are reported, or at least easily observed.
- The terms of the derivative contracts are standardized, and relatively simple.
- The contracts themselves are traded on an open market, and their trade prices are reported
- The derivative transactions are settled via an organized exchange or clearing house, which acts as one party to each transaction, and sets capital provision rules for the participants (for example, the required posting of earnest money deposits or “margin”).
- In part because the contracts are standardized, there are published, widely-examined industry standards for the valuation and risk assessment of the contracts.
With all this, it would seem that these markets would be fairly orderly, as in fact they are. So why then, back at the end of 2002, did Warren Buffet, arguably the most successful investor in the world, say that derivatives were “financial weapons of mass destruction”, in his annual letter to the shareholders [PDF] of Berkshire Hathaway? I’ll start to explore that in the next post.
Opera Software has released a new version of its Opera Web browser, version 10.10. It is available for these operating systems: Windows, Mac OS X, Linux, FreeBSD, Solaris (Intel or SPARC), QNX, OS/2, and BeOS, and can be downloaded here. This version contains a number of new features, including Opera Unite, a technology for sharing information with colleagues or friends, and Opera Link, a facility for synchronizing bookmarks and other data across multiple computers. There are also improvements to the user interface, search functions, and security. In addition to the Web browser, Opera also includes an E-mail client.