Derivatives
Topic D: Derivatives (e.g.. options, futures) are often criticized for being too risky and causing massive losses to investors (e.g. Barrings Bank, LTCM). Explain the role of derivatives in financial markets and their desirable and undesirable uses.The use of derivatives in the financial market has dramatically increased in recent years. This relevantly recent change in the status of derivatives has led to calls for increased regulation. Fears that using derivatives to hedge against risk carries in itself a new risk which was brought sharply into focus by the collapse of large major financial institutions such as LTCM and Barrings in 1995.To explain the role of derivatives in the financial markets, we need to understand what derivatives are, how they can be used to minimize risk and why there is such an increasing pressure to increase regulation on the use of derivatives as a financial tool.Derivatives are financial contracts whose value derives from underlying securities prices. For example: Interest rate, foreign exchange rates, market indexes or commodity prices. Exchange-traded derivatives are standardized products traded on the floor of an organized exchange and usually require a good faith deposit, or margin w
At the same time inter-linkages also mean that disruptions in OTC activities necessarily entail spillovers and contagion to these other markets. They are increasingly becoming an important instrument in the global finance world. However derivative instruments used as risk management tools have potential to be more risky than the underlying cash instrument, though the exchanges on which many derivative instruments are traded help to spread risk"For an example of how derivatives work, suppose we consider a Small Regional Bank (SRB) with total assets of $5million. Over-the-counter (OTC) derivatives such as currency swaps and interest swaps are privately negotiated bilateral agreements transacted off organized exchange. The inter-linkages and the opportunities for arbitrage that they provide add to the efficiency and complicity of the international financial system. About half or more of OTC derivatives trading in the largest segments takes place across national borders. The severity of repeated episodes of turbulence and in particular the contours of the market dynamics in the aftermath of the near collapse of LTCM, suggest the OTC derivatives activities are capable of producing instability in some cases akin to a modern form of traditional bank run. By entering into derivatives contract, the SRB can lock in a guaranteed rate of return on its securities portfolio and not be as concerned about interest-rate volatility". html )OTC derivative activities can contribute to the buildup of vulnerabilities and adverse market dynamics in some circumstances. But by selling short a $1million treasury-bind futures contract, the SRB can effectively hedge against that interest-rate risk and smooth its earning stream in a volatile market. They can use derivatives to hedge their risks: Rising interest rates will negatively affect prices in the SRB's $1 million securities portfolio. Using financial derivatives should be considered a part of any business's risk management strategy to ensure that value enhancing investment opportunities can be pursued. If interest rates went higher, a drop in value of its securities portfolio would hurt SRB, but that loss would be offset by a gain from its derivative contract.
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Acceptance Essays
