> Nothing is constant. Nothing is the way it's always been. So what I find is that people who are really good at this have great intuition. They have great instinct. Their gut actually tells them something. The mathematics are important, because they demonstrate you understand the problem. But ultimately, the decision about whether or not to take a given risk, I think, is really a human judgment call in every sense of the word. The origins of hedging, appropriately enough, are agricultural. For a farmer, nothing is more important than the future price of his crop after it's been harvested and brought to market. But that can be higher or much lower than he expects. A futures contract allows him to protect himself by committing a merchant to buy the crop when it's bought to market at a price agreed when the seeds are being planted. The farmer gets a floor below which the price can't sink. The merchant gets a ceiling above which it can't rise. By signing a futures contract, both the farmer and the merchant have hedged their bets.
> Both parties are better off, and because of that, the world as a whole is much better off. It encourages capital formation. It encourages investment. It encourages people to do what is needed to be done to make the world a better place.
[wind rustling]
> With the development of a standardized futures contract, agreeing rules, and an effective clearing house, the first true futures market was born. And its birthplace was here in the windy city: Chicago. After the city's futures exchange was established in 1874, hedging commodities became standard practice. The next step was for a conditional kind of future to evolve: the option. Some of this really is the financial equivalent of rocket science. But the underlying principle is simple. Because they're derived from underlying assets,all futures contracts are known as derivatives.But an even smarter kind of derivative is an option. The buyer of a corn option has the right, say, to buy a barrel of oil for $120 in a year's time. Now, if the price of oil rises to about $150 a barrel, then the option is in the money, and the smart guy makes a profit of $30. But if that doesn't happen-- if the price of oil stays the same or actually declines, he's under no obligation to carry through the deal. All he does is to write off the cost of the option itself. Well, it's by buying and selling complex smart derivatives like options that Ken Griffen has become a billionaire.
[people shouting] In theory, derivatives offer a new way to hedge against an uncertain future, a much smarter way than boring old insurance, and much more profitable. In the past decade, derivatives have seemed to take over the world of finance. By the end of 2007, the notional value of all derivatives contracts reached a staggering $596 trillion. That's 43 times the size of the American economy.
[people shouting]
> There are tremendous economic benefits for people that work here. $20 billion in the hands of a thousand people is really a 21st-century phenomenon. This never happened 50 years ago.
> Yet there are downsides to hedging too. When billionaire investor Warren Buffett described derivatives as financial weapons of mass destruction, he all but prophesied the downfall of American insurance giant AIG, whose European headquarters are there behind me, brought low not by selling insurance policies, but by selling derivatives that blew up in its face. Our basic human urge to protect ourselves against risk has proved frustratingly difficult to satisfy. Insurance companies let us down. Welfare states sink into insolvency. And derivatives turn out to be a double-edged weapon too.
[birds cawing]
[gunshot] And so for many families, providing for the future now takes one very simple form: an investment in a house, the value of which is supposed to keep going up until the day the breadwinners need to retire. If the pension plan falls short, never mind. There's always home sweet home. As a pension or an insurance policy, this strategy has one very obvious flaw. It represents a one-way, totally unhedged bet on a single market: the property market. But as we'll see in the next episode of The Ascent of Money, a bet on bricks and mortar or good old Japanese wood is anything but As Safe as Houses.