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Lynch: Understanding Derivatives

Timothy E. Lynch, professor at the Indiana University Maurer School of Law - Bloomington, has published a paper designed to help make the complex world of derivative financial instruments more understandable to financial professionals and the lay community.  His paper, "Derivatives: A Twenty-First Century Understanding," provides "a framework for understanding modern derivatives by identifying the characteristics all derivatives share."

Lynch's paper takes a practical, as opposed to technical, approach to understanding the otherwise complex contractual and technical workings of derivatives.  His paper is intended to help "facilitate the development of more rational and comprehensive derivatives regulations, including (i) those required under the recently enacted Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act) and (ii) those addressing the particular risks associated with "purely speculative derivatives," (those in which neither party is hedging a pre-existing risk)."

According to the paper's abstract: 

Derivatives are commonly defined as some variation of the following: a financial instrument whose value is derived from the performance of a secondary source such as an underlying bond, commodity or index. But this definition is both over-inclusive and under-inclusive. Thus, not surprisingly, derivatives are largely misunderstood, including by many policy makers, regulators and legal analysts. It is important for interested parties such as policy makers to understand derivatives, because the types and uses of derivatives have exploded in the last few decades, and because these financial instruments can provide both social benefits and cause social harms. This Article presents a framework for understanding modern derivatives by identifying the characteristics all derivatives share.

All derivatives are contracts between two counterparties in which the payoffs to and from each counterparty depend on the outcome of one or more extrinsic, future, uncertain event or metric and in which each counterparty expects such outcome to be opposite to that expected by the other counterparty. The framework presented in this Article will facilitate the development of more rational and comprehensive derivatives regulations, including (i) those required under the recently enacted Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act) and (ii) those addressing the particular risks associated with "purely speculative derivatives," (those in which neither party is hedging a pre-existing risk).

The paper may serve fund directors and others as a tool to better understand how derivative instruments work, and why they are used.

The full text of Lynch's paper is available at:  http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1785634