. December 29, 2005 SouthAmerica: I wish that more people on Wall Street and in the US government had a better understanding of the âDerivatives Marketâ. In a Nutshell: Warren Buffett says derivatives are weapons of mass financial destruction. Warren Buffett is the world's greatest stock market investor since the 1960âs. Quoting from this article: âIn 2006, the derivatives market will grow to nearly half a quadrillion dollars (fourteen zeros), more than 10 times the world's domestic product. Even if lobbyists are correct that derivatives are good and are used mostly for hedging, it is unclear why anyone would need to hedge the entire world's domestic product more than once.â **** âInvesting in fantasy landâ By Frank Partnoy Published: December 28 2005 The Financial Times of London â¦ Most people assume that markets are dominated by tangible assets such as shares and bonds. But â¦investors in 2006 will discover a bewildering array of new products, ranging from specialised exchange traded funds to virtual investments that do not actually hold any financial assets, but instead use derivatives to mimic those assets. Just about anyone who entrusts money to a fund manager will own some of these products. In 2006, the derivatives market will grow to nearly half a quadrillion dollars (fourteen zeros), more than 10 times the world's domestic product. Even if lobbyists are correct that derivatives are good and are used mostly for hedging, it is unclear why anyone would need to hedge the entire world's domestic product more than once. Institutions will continue to buy new forms of hybrid and structured investments, financial animals every bit as strange as the faun and talking beavers of Narnia. Two popular products, so-called "portable alpha" and synthetic collateralised debt obligations, attempt to replicate bond returns without owning bonds. The hot security for early 2006 is called an Ecaps, a crossbreed of shares and bonds. Retirees will be in an even more mystifying place next year, where companies and governments that are technically bankrupt pretend they can pay pensioners by making increasingly risky bets. According to one view, the central villains are self-indulgent chief executives who will reap oversized option grants, hoard shareholder capital and spurn employees, just as the White Witch belittles her dwarf and wolf servants. In 2006, the average American chief executive will be paid more than 300 times the average employee's salary. A contrary view blames activist hedge funds, which force managers to sacrifice long-term corporate interests at the altar of short-term shareholder value. Next year, numerous hedge funds will acquire small ownership stakes in companies and demand radical change, just as Carl Icahn, who recently bought 3 per cent of Time Warner, is pressing that company to split into pieces. On nearly 400 occasions during 2005, a hedge fund acquired 5 per cent of a company's shares and filed papers showing it was ready to brawl. During the upcoming year, that number will double. People might disagree about which group is evil, but both perspectives highlight the recent structural changes in markets. The issue with CEOs arises not merely from the amount of executive pay, but from its option-heavy composition; likewise, the complexities of modern financial reporting insulate CEOs from attack. Who can read the 100-plus-page financial reports of AIG, General Electric, or JPMorgan Chase and say whether those companies are well managed? Soaring hedge fund activism arises from the evaporation of other profitable strategies, as traditional arbitrage becomes more competitive, yield curves flatten and markets become less volatile. Hedge fund managers are guided to strike at corporate managers, not by any moral sentiments, but by Adam Smith's invisible hand. The central question for 2006 will be whether shareholders are better served by hedge funds, which seek short-term profit, or corporate managers, who consider long-term value. It is a new, more sophisticated spin on an old problem: in whose interest should the company be run? Anyone who sees markets as driven primarily by economics will favour hedge funds and will see companies as mere financial instruments that are useful only to the extent that they generate profits for shareholders. Anyone who sees markets as essentially political will favour corporate managers and will see companies as an amalgam of constituencies - shareholders, employees, customers and community - whose competing interests require the skills of an astute mediator. For anyone who likes not only to invest, but to think about investing, 2006 will be a year of enchantment and mystery. There is a deep magic at work in the financial markets. The writer is a professor of law at the University of San Diego and a former banker at Morgan Stanley. He is author of Infectious Greed: How Deceit and Risk Corrupted the Financial Markets (Henry Holt/Profile) You can read the entire article at: Source: http://news.ft.com/cms/s/27729a00-7746-11da-a7d1-0000779e2340.html .