Over at Tech Central Station, I've written an article that takes a closer look at the reasons why so many people are afraid of financial derivatives. Most people are OK with the idea of common derivatives like options and futures -- but they tend to get a bit more bent out of shape when it comes to exotics like collateralized debt obligations or housing market derivatives or interest rate swaps. One basic problem is "folk finance" -- the tendency for people to take refuge in misguided, intuitive beliefs anytime that they don't understand the financial markets. As a result, they turn to the mighty hand of government to regulate away these perceived risks. Anyway, there's a double meaning to the title ("Derivative Thinking"), since part of the essay derives from some very fine thinking by one-time Corante blogger Arnold Kling.

Here's an excerpt from the piece:

"While regulators should be applauded for their attempts to make market participants more aware of the risks of using derivatives, these fears are overstated. As TCS Contributing Editor Arnold Kling pointed out in part six ("The Proper Attitude Toward Financial Regulation") of an earlier six-part series on financial markets, regulators and laypersons alike tend to approach the issue of risk from the wrong perspective. They do not always recognize that new-fangled financial instruments like credit derivatives, instead of creating risk, are actually a response to risk that already exists within the economic environment. Derivatives allow investors to re-allocate or transfer away diversifiable risk in ways that make financial markets more transparent, more efficient and more liquid... Derivatives seem to be pesky little creatures that always appear in all the riskiest markets. That makes sense, of course, if you believe that financial derivatives do not create risk -- they are a response to risk."