Recently, I was speaking at a luncheon for retired executives. One attendee asked me, point blank, what derivatives are good for and why we need them. It was a simple question, and it got me thinking about the answer.

Analogy: insurance policies

Before I address the question of why we have derivatives, I want to draw an analogy with insurance policies. Why do we have insurance policies? Would we be better off without them?

The answer, of course, is that insurance is critical. We carry automobile insurance so that we know we have coverage in case we cause a car accident. Maybe even more important, we trust that other drivers have automobile coverage, so that if they cause an accident, there is coverage for liabilities and injuries.

The same principle goes for life insurance, house insurance, fire insurance, and any other type of insurance. Insurance offsets risk.

Derivatives

Similarly, derivatives are primarily used to offset risk. Specifically, they provide insurance for portfolios and assets in the event of adverse market conditions that affect the value of the holdings. Firms write derivatives as insurance against these adverse events.

And while firms sell the derivatives at a premium, they must have the capital reserves to pay you if your derivatives contract comes due.

Is that an accurate analogy?