Wednesday, November 07, 2007

With Derivatives At An All-Time High, US Economy Can Handle $100 Oil, Falling $ and Subprime Crisis?

I blogged before about why "The Energy Efficient Economy Can Handle $100 Oil," and Greg Mankiw linked to that CD post on his blog asking "Where have all the oil shocks gone?" As Mankiw summarized, "The economy is far more energy-efficient today than it was in the past, in part because economic activity is based more on services and less on manufacturing. As a result, energy prices matter less today."

Another reason that the U.S. economy today can handle record oil prices, a falling dollar, and increasing credit risks, without going into recession? Price, currency, and credit risks have been hedged effectively using derivative contracts (futures, options, swaps, etc.), insulating the U.S. economy more than ever before from oil shocks, currency risk and the subprime mortgage crisis.

As the top chart above shows, the volume of futures contracts at the Chicago Mercantile Exchange is at an all-time historical high, and have increased by a factor of 6X between 2000 (231 million contracts) and 2006 (1.403 billion).

Likewise, the value of derivative contracts (according to the OCC) held by U.S. commercial banks in 2007 ($152 trillion) is almost 11X 2007 U.S. GDP ($14T), compared to a ratio of 2:1 in 1994 (see bottom chart above) for Derivative Contracts:GDP.

Bottom Line: With derivative trading at an all-time historical high, which allows for low-cost effective hedging of price risk, currency risk, interest rate risk and credit risk, the U.S. economy of 2007 has been able to easily accommodate oil shocks, a falling dollar, and the subprime mortgage crisis, without the risk of recession.


At 11/08/2007 2:19 AM, Anonymous Anonymous said...

I guess derivatives only hedge temporarily risks up until their expiration date. If the shocks are permanent, derivatives can at best delay the impacts on the real economy for a few months.

At 11/08/2007 6:37 AM, Anonymous Anonymous said...

Markets and Dollar Sink as Slowdown Fear Increases - NY Times Nov. 8, 2007

“We are experiencing among our clients an awakening that the United States is in big trouble”

The rise in oil prices, which briefly traded yesterday above $98 a barrel before settling at $96.37, now appear to be pushing up the cost of gasoline, heating oil and jet fuel as well. That only intensified concern that American consumers may no longer be able to sustain their spending on other goods and services...

Our service economy does not use as much energy as it did when it was more manufacturing based. It isn't that we are more efficient so much as things have changed.

We are dependent upon (sometimes inefficient) manufacturing that is carried out in other countries.

Until now using cheap human labor has been key to outsourcing success in manufacturing but now $100 oil is going to hurt us as imported goods prices rise due to increased energy costs.

At 11/08/2007 7:42 PM, Anonymous Anonymous said...

read brookstaber ( a practitioner) A demon of our Own design on how derivatives "limit risk",

The massive losses at the ibanks come from people taking on MORE risk because they were over confident of their hedging models. To give a simple example hedging interest rates with a bond or euro dollar (part of the cme numbers you counted) leads a holder of cdos complacent that he is hedged and he takes on more paper. But in fact the bigger risk that he didn't hedge was the credit risk not the interest rate risk. And there was no cme contract for that.

your argument is nonsense Morgan Stanley lost most of the three billion it wrote off in derivative trades. Without the derivatives they would have never been able to take the risk. The $ volume traded in currency derivatives on the euro in one week is more than the entire volume of intl trade between the us and the euro zone in a year. Clearly the players aren't hedgers rather speculators that thrive on volatility.

At 11/10/2007 12:40 AM, Anonymous Charles D Quarles said...


Quit picking on the "speculator" specter. Everyone who participates in markets is by definition a speculator. IOW a speculator is the guy selling when you're buying. A speculator is the guy buying when you're selling.


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