Against the Gods: The Remarkable Story of Risk

Chapter 18

The Fantastic System of Side Bets

Derivatives are the most sophisticated of financial instruments, the most intricate, the most arcane, even the most risky. Very 1990s, and to many people a dirty word. Here is what Time magazine had to say in an April 1994 cover story:

[T]his fantastic system of side bets is not based on old-fashioned human hunches but on calculations designed and monitored by computer wizards using abstruse mathematical formulas . . . developed by so-called quants, short for quantitative analysts.

We have just looked at the fantastic system of side bets based on old-fashioned human hunches. Now we turn to the fantastic system concocted by the quants.

Despite the mystery that has grown up about these instruments in recent years, there is nothing particularly modern about them. Derivatives go back so far in time that they have no identifiable inventors: no Cardano, Bernoulli, Graunt, or Gauss. The use of derivatives arose from the need to reduce uncertainty, and surely there is nothing new about that.

Derivatives are financial instruments that have no value of their own. That may sound weird, but it is the secret of what they are all about. They are called derivatives because they derive their value from the value of some other asset, which is precisely why they serve so well to hedge the risk of unexpected price fluctuations. They hedge the risk in owning things like bushels of wheat, French francs, government bonds, and common stocks—in short any asset ...