Wharton's article has touched most of the important topics related to financial innovative products. There are three other things that are not addressed however:
1. Counter-party risk: the solvency of the counter-party must be considered and must be evaluated under some three-sigma events. When the tsunami comes, you don't want to be right but still be left with the baggage from your counter-party.

2. Cross-correlation of the financial instruments: this needs to be addressed for your own portfolio and your counter-party's portfolio if possible. The correlation and its potential variation range must be carefully considered. Using efficient frontier, one can potentially absorb high volatility and balance it (through some other negatively correlated instrument) in an entire portfolio.

3. Market efficiency: The risk of a financial product is always proportional to the return. Even if there is a temporary market inefficiency that allows one to arbitrage, such inefficiency (and therefore opportunity) is bound to disappear as the capital that participates in such opportunity expands dramatically. Such process of exploiting market inefficiency is itself making the market efficient again. So no matter how innovative the financial instruments or strategies are, one should not delude oneself into thinking that such edge can last forever.

"Financial innovations arise because of demand," I believe that the majority of independent investors are interested in attaining a reliable return on investment, which increases their real wealth, with minimal risk to their capital. Later in life, independent investors want their investments to produce a reliable income stream with minimal risk to their capital. Financial innovations, such as those mentioned in the article, may be in demand by institutional investors but, I doubt that they serve the wants and needs of most independent investors.

“The more complex the financial instruments are, however, the more skill is needed in understanding and using them.” The reason that financial innovations are not in demand by most independent investors is simply because they are complex and risky. In general, independent investors will lose in a zero sum trade with institutional investors. Institutional investors have the advantage of expertise, time and money to devote to trading. Independent investors are well advised to stay away from derivatives and other “financial innovations”.

Unfortunately, financial innovations are starting to impact and overpower the machinations of traditional independent type investment. There is a dire need for protective oversight of the capital markets. Financial innovations have become a threat to the wellbeing and quality of life of the typical individual investor. Left unchecked, in time institutional investors will hold all of the wealth and independent investors will be left holding the bag.

ALOHA !!

QUOTE ...
"Taking a risk is not a bad thing," he said. "That is why we invest. Prudent investment choices arise from direct recognition of the risk, understanding of risk, and diversification of risk."
—Christopher C. Geczy, Assistant Professor of Management, The Wharton SchoolEND

RISKY BUSINESS
Risk in real terms has always been an element of "life", from the sense that even walking out your front door to go to work has risk. Some people make a living from jobs that have a large amount of risk, like an iron worker who works 400 feet off the ground walking on a thin steel beam. Typically those jobs pay more due to the higher level of risk. Many physical risks are easily visible, but the new innovations such as derivatives have limited visibility(transparency) to the general investing public in terms of visible risk. To assess these risks the average person on the street would have to access information that is really only privy to the investment banks that originate and control the derivatives contracts. How can you assess the solvency or the ability of a counter-party bank? Do you just go online and view last quarters financials? From the latest headlines it seems that even large investment banks like Merrill Lynch and Bear Stearns cannot even assess risk adequately in the derivatives market, so how can an average investor on the street be sure they know counter-party risk? Many times during Alan Greenspan's tenure as Chairman of the Federal Reserve Bank he was questioned directly in front of Congress regarding the "regulation" of the derivatives market. He advised that these markets required no "regulation". The problem with that is typically "regulation" only comes after a catastrophe. Many new laws regulating the stock market came only after the 1929 Crash. Now as we see many banks posting huge losses due to derivatives perhaps Greenspan will conceed a "little" regulation is not such a "bad thing!"

THERE'S RISK AND THEN THERE'S RISK
It seems there has been a quest for unlimited profits coming from Wall Street of late. CEO bonuses would attest to that ... New innovations such as derivatives are there for a purpose. The main reason is to increase Wall Street profits. In order for Wall Street to have profits there needs to be a counter-party that can sustain losses.

When the average investor takes on risk they know there is no 100% insurance against failure and loss. When Goldman Sachs takes on an inordinate amount of risk they know they will be "bailed out" by the "lender of last resort" the Central Bank, an exclusive private entity in which they are a member. Therein lies the fraud ... Central Banks are not the "lenders of last resort" that title goes to the US Taxpayer. The US government and its Treasury are wholly dependant on tax revenues from tax payers. The US government creates no wealth, but only transfers it. The Federal Reserve Bank "prints" the funds(wealth) needed for a bailout but does not create the wealth needed to satisfy the debt which they themselves created. When I as a taxpayer take on too much risk and fail my only recourse is bankruptcy court. In the "real world" of RISK there is no level playing field.

QUOTE ...
Geczy notes that innovations that were shocking and controversial when they were first introduced later have become widely accepted. "Remember that securities trading on organized exchanges itself was once an innovation," he said. "Now it feels very plain vanilla."END

THE PAIN OF PLAIN
In order to become "plain vanilla" markets had to go through some "pain" ... Many investors and financial institutions have failed and are now insolvent from past "trading on organized exchanges" that started at the turn of the last century. The current "plain vanilla" markets we have today were distilled and refined from the pain of failure into what most investors see as "free markets" where transparency is sufficient to make risk tolerable. Investors now feel "confident" enough to trade past "innovative" markets. That "confidence" is all that holds up every global exchange. When that "confidence" dissipates so do the markets, including the vanilla ones.

PLAYING FIELDS
It would be a level playing field if the "risk" from failure were equal between banks and individual investors. I submit that there would be far less "innovation" if this were not a fiat based monetary system and investment banks were made to toe the "risk", knowing that if they failed they would be taken over by the US Treasury and the US Taxpayer would become their creditor whereby the management and the banks holdings would be subject to forfeiture and sale in order to repay the banks debt. What happens today is the complete opposite. Irresponsible management and their banks are allowed to continue operating with little to no restructuring or regulation. In some cases the CEO and management even get bonuses ... To combat the Mafia there is the RICO statuates, perhaps we need to apply that same strategy to Wall Street banks and brokerages? The saying "TOO BIG TO FAIL" is a product of this environment that could only exist under a fiat monetary regime. What we have now is not "plain vanilla" it is just "plain fraudulent and immoral". When even a bank CD is seen as risky then there is something very wrong with the financial system.

Derivatives have yet to prove they are "plain vanilla" or for that matter just "plain", never mind the flavor!

ALOHA !!

Bill add this to my prior post ...

WHY WE INVEST
Most investors are in the markets because they perceive a need to maintain their lifestyle that they see slipping away due to price inflation which is directly attributable to monetary inflation and the erosion of the US Dollar's worth. More people sign up with ETrade or Schwab because they need to "leverage" their pay check or their social security check. Fiat money by its nature is inflationary because it is subjected to the whim of the human condition and its ego. The fact is that wages are lagging inflation substantially, unless you are Oprah or Warren Buffet. What our grandparents once considered as adequate pay is now inadequate to meet the ever rising costs of living. The choices become lower your standard of living or leverage your income. Few Americans choose freely to lower their standard of living. At some point there becomes no other choice.

We invest because we know we have to ...

Counter-party risk requires you to know the counter-party. On established exchanges this is typically a market maker or clearing corporation. When a bank establishes a conduit as a means of making loans that are not carried on the bank's books, who is the counter-party? Is there an implicit relationship with the sponsoring bank? Certainly the bank's lawyers will say "NO", but how does a customer or rating agency think? I know personally I have tended to assume (falsely) that large organizations will stand by their offspring. As an individual investor, how can I evaluate risk in such a "simple" entity as a money market fund? In the past I've never bothered, assuming again that organizations such as AIM and Fidelity have enough brain and computing power to do it for me, and thats why I pay their fees. Yet there have been cases in the past where the $1 value has been broken (not AFAIK at Fidelity or AIM), so I'm left with the choice of Treasury only funds/FDIC insured bank accounts (that as Kaimu points out, guarantee loss via inflation and taxation) or some degree of gambling because I cannot personally evaluate the counter-party risk of OTC transactions.

Prof. Geckzy states that: “we should not… be quick to equate financial innovation with outsized risk or losing money." If the opinion of investors is to equate innovation with excessive risk, then this is a recent development.

I think recent history indicates that the natural inclination of investors is to stay ahead of the power curve in the quest for alpha by purchasing the latest and greatest innovations. The more complicated the innovation, the more necessary it becomes to trust both the issuer of the innovation and especially the ratings agencies.

This blind faith has been shattered. A large number of investors did not realize that all AAA rated products are not equally safe to purchase. The problem in the credit markets today is largely a justifiable lack of confidence. The lesson is to never buy something if you do not know exactly how it is composed. Confidence must be restored if the alphabet soup of leveraged products is to remain over the long term, and in order for innovation to continue to be accepted.

What I noticed right away in the article is the implicit assumption that the burden is put entirely on the "investor" to be aware of the risks of these investments, etc. But you would have to have a strong mathematical bent in order to appreciate how these instruments behave. For example, using options as an example, in the Black and Scholes formula, perturbing which variables leads to the most change in the option value? Alexander Elder makes it clear why buying options is a bad idea--because you've got three things going against you at once, the choice of stock, the direction of the move of the underlying, and the timing--you are jumping through three hoops at once. Not to mention that options are no longer priced with the simple Black & Scholes formula and are consequently even more dangerous, just to cite options as an example.

Is the emphasis on the investor assuming all the risks of these vehicles really fair in the enviroment we're in? You've got exogenous variables that also affect risk such as black box trading that tends to phase lock in a crisis, the dismanteling of the Glass-Steagle protections which has led to off-balance-sheet SIVs which introduces yet more systemic risk. I find this one-sided emphasis in the Wharton document disingenuous. In addition there is the unconscionable shifting of risk to the investor due to self-policing and non-disinterested actions by intermediaries.