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Derivatives contracts are complex. So complex that in order to understand them, the great majority of commercial investors (let alone average people) have to hire "quants" or mathematical gurus to guide them through the complexities.
The complexity of derivatives contracts is not to be minimized nor denied. They are deliberately made complex. Since they are so complex, they have largely escaped regulation.
Including Insurance Regulation. Derivatives contracts offer "insurance, for example, on trading positions". Louis Uchitelle, "Elders of Wall St. Favor Tight Rein" p. B1, col. 2 (New York Times Nat'l ed., "Business Day" Section, Wednesday, February 17, 2009).
A good explanation of the purposes and results of derivatives contracts is given by Christopher Emsden, "Derivatives Promise Pain for Italians" p. C2, col. 6 (Wall Street Journal, "Money & Investing" Section, Thursday, February 18, 2010) subscription required to access Online Edition.
Mr. Emsden explains in his report that the debts assumed under derivatives contracts can last for 20 to 30 more years. Greece reportedly used them on a large scale to avoid European Union Rules on the amount of debt member states are allowed to carry. Municipalities in Italy have reportedly entered into $48,000,000,000.00 or $48 Billion worth of derivatives contracts. "That is equivalent to almost a third of all debt held by Italy's regions, provinces and municipalities." Id. Italian municipal governments often used derivatives contracts "to protect public bond issuers against adverse interest-rate movements," Mr. Emsden reports.
Not being very well versed, myself, in the world of derivatives contracts or in finance for that matter, I take this to mean that the municipal governments used derivatives contracts to insure against unwanted increases in the interest rates that they would have to pay on their bonds; in the event that the interest rate exceeded a certain amount, derivatives contracts would provide insurance which would pay all or part of the excess.
Different kinds of derivatives contracts may serve the different purposes of different kinds of Insurance Policies. The kind of derivatives contracts that are used by munis "to protect public bond issuers against adverse interest-rate movements" walk and talk like Bond Insurance. Munis in the United States have suffered with Bond Insurance Companies and Credit Rating Companies, as readers of this space know. See generally the posts filed on this site in the Category of "Bond Insurance". It appears that in the future, munis in the U.S. may soon feel the same pain that munis in Italy are reportedly experiencing, with derivatives contracts, i.e., unregulated Bond Insurance.
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