12/19/2008 A stock certificate is a derivative contract to use leverage to acquire a corporate asset.

There are plenty of derivatives bashers out there who often express naive comments about the role of derivatives in our current economic crisis. The generalization is usually due to ignorance of financial common sense. Few people realize that almost all of our modern day financial contracts and transactions are in fact derivative contracts, some are simple and others more complex. A simple stock certificate is actually the best example of a simple derivative contract.

One of the most basic economic advantages of derivatives is its ability to provide leveraging. As explained before that the underlying abuse of leveraging is the culprit of most of the disastrous collapses of asset bubbles. Derivatives instruments are just some of the convenient tools that facilitate the use of leveraging. Derivatives contracts could be as complicated as an option contract on a stock, a bond, a currency pair or a mortgage loan or it could be as simple as a stock certificate itself.

Our previous depression in the 30’s was led by a stock market collapse in the 1929. There weren’t any sophisticated options, forwards, swaps, CDOs or CDS back then. People simply used the stock certificates to acquire assets to build up the bubble. Other than the more obvious use of leverage through margin trading, the more subtle inherent leveraging is that the corporation uses leverage themselves to run the corporate business and issue stock certificates to represent leveraged partial ownership. Some corporations are more levered than the others and hence deemed to be riskier investments. From a theoretical point of view, a stock certificate is nothing different from a call option of the corporation’s assets so that leveraging is realized in the ownership. It is really the most basic form of a derivatives contract.

Having this new understanding you may be surprised to find out that a traditional Graham & Dodd stock market investor could be in fact one of the most successful derivatives traders of the world. For those people to call derivatives the Weapons of Mass Destruction sounds really like a gay bashing politician who is actually gay himself.

So financial derivatives concepts and instruments are here to stay. Like many of our other modern day inventions such as electricity or nuclear power. We will have to learn to better manage and control them in order for them to do more good than bad things to our society by keeping them away from being abused due to people’s greed. Having a few occasional abusive accidents should take us back to the drawing board to design better and more robust financial contracts for the future rather than giving the ignorant folks the excuse of throwing in the towels and calling it the end of the capitalism society.

As I mentioned many times before, an Amish man may tell you “I told you so.” when he sees a car wreck on the road. That shouldn’t stop us from building better cars and designing better traffic rules. It would be quite stupid to go back to ride horse-drawn buggies again simply because this Amish man got a confirmation of his belief for himself.

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