Financial Disaster

Computers have permitted the development of very sophisticated financial instruments called derivatives. Derivatives can play a positive role in the financial operations of a company by providing a hedge against risk. However, several companies (Barings, Ltd) and even governmental bodies (Orange County, CA) have found themselves in deep trouble through the use of derivatives for speculation rather than as a hedge. The principal reason for this is that management could not recognize the difference between legitimate and speculative uses of derivatives, primarily because they did not understand these arcane objects that can only be priced through complex computer calculations.

Very similar kinds of computer calculations were used by Enron to calculate the present value of long term natural gas contracts brokered by Enron. This led to the use of "Mark to Market" for the reporting of Enron's income. As we shall see ultimately this tool, while completely justified by economists, led to the climate that created Enron's downfall.