Big Risk: $1.2 Quadrillion Derivatives Market Dwarfs World GDP

Thursday, June 10, 2010
By Paul Martin

By PETER COHAN
DaolyFinance.com

One of the biggest risks to the world’s financial health is the $1.2 quadrillion derivatives market. It’s complex, it’s unregulated, and it ought to be of concern to world leaders that its notional value is 20 times the size of the world economy. But traders rule the roost — and as much as risk managers and regulators might want to limit that risk, they lack the power or knowledge to do so.

A quadrillion is a big number: 1,000 times a trillion. Yet according to one of the world’s leading derivatives experts, Paul Wilmott, who holds a doctorate in applied mathematics from Oxford University (and whose speaking voice sounds eerily like John Lennon’s), $1.2 quadrillion is the so-called notional value of the worldwide derivatives market. To put that in perspective, the world’s annual gross domestic product is between $50 trillion and $60 trillion.

To understand the concept of “notional value,” it’s useful to have an example. Let’s say you borrow $1 million to buy an apartment and the interest rate on that loan gets reset every six months. Meanwhile, you turn around and rent that apartment out at a monthly fixed rate. If all your expenses including interest are less than the rent, you make money. But if the interest and expenses get bigger than the rent, you lose.

You might be able to hedge this risk of a spike in interest rates by swapping that variable rate of interest for a fixed one. To do that you’d need to find a counterparty who has an asset with a fixed rate of return who believed that interest rates were going to fall and was willing to swap his fixed rate for your variable one.

The actual cash amount of the interest rates swaps might be 1% of the $1 million debt, while that $1 million is the “notional” amount. Applying that same 1% to the $1.2 quadrillion derivatives market would leave a cash amount of the derivatives market of $12 trillion — far smaller, but still 20% of the world economy.

Getting a Handle on Derivatives Risk

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