50 Years On: Are Derivatives a “Product from Hell”? Historical Perspectives on 30 Cases of Derivatives Losses

Financial derivatives have been consistently stigmatized. Undoubtedly, most if not all of the negative press arises from high-profile cases of companies that lost significant amounts of money with these products—the so-called derivatives debacles. These products are unique in the sense that, unlike any other financial instrument, some critics have consistently argued for their demise. This article aims to answer the question of whether this criticism is justified from a historical perspective by analyzing the 30 largest losses caused by financial derivatives among non-financial end users from 1987 to 2017. The results of this analysis do not support most of these accusations. The data show four main patterns: (1) All the derivatives products in the sample performed as expected, and all the losses resulted from wrongly timed market strategies. No losses were attributable to operational or legal reasons. (2) In the overwhelming majority of cases, these derivatives strategies were deliberately not designed as bona fide hedges but instead were used to attain off-market rates or extraordinary returns at no upfront cost for the users (“speculative hedging”). (3) Given their academic background, most end users likely did not fully grasp the math behind the most complex strategies, but they seemed to understand the risk-return tradeoffs of their strategies because they agreed to assume additional market risks to achieve off-market rates with no upfront costs. Moreover, having a deep understanding of derivatives was not a guarantee of success. Some of the executives responsible for the largest losses in our sample have mathematical or advanced finance backgrounds. (4) Most financial managers flagrantly underestimated the likelihood of extreme market events. In general, these losses happened after a period of persistent market trends. Financial managers therefore believed that recent market trends would continue for the foreseeable future and overlooked the risk of extreme and unexpected market moves.