CHAPTER I: INTRODUCTION During the last 30 years, derivatives have become increasingly important and widely used in the field of finance all around the world. Their increasing values made them impossible to be ignored because they have become much bigger than the stock market when measured in terms of underlying assets in so much that Global corporations and financial intermediaries trade billions of dollars of derivative contracts on a daily basis across a range of products and markets (Batten and Wagner, 2012). However, some critics pointed out that “derivatives implication has contributed in the collapses and bankruptcies of financial institutions such as Barings Bank in 1995, Long-term Capital Management in 1998, Enron in 2001, Lehman Brothers and American International Group (AIG) in 2008” (Michael Chui 2012). Even Warren Buffett argued in 2003 that “derivatives are financial weapons of mass destruction that could harm not only their buyers and sellers, but the whole economic system” (News.bbc.co.uk, 2003). Thus it is noticeable that opinions about derivatives are biased. Therefore, throughout this work, I will aim to investigate at the differences between future and option contracts with a critical analysis on the evidence presented. The work will be divided into 3 parts which are Chapter 2, chapter 3 and the conclusions. The chapter 2 will about literature review where will be discussed the definitions of futures and options contracts as well as their differences
Analyze the derivatives market and determine the use of derivatives to efficiently manage investment risks in an investment portfolio.
In fact, the five elements that affect the proper use of derivatives include perception, benefits, misuse, expertise, risk management controls. The financier will gaze the misuse of derivatives to point out a greedy person. When firms lose billions of dollars, one could argue that these catastrophic losses are based on the misuse of derivatives, but not their qualities. Consequently, human greed
One must pretend to know the broad and yet differentiated world of banking and equity portfolios without bothering to actually learn about them. Use words such as ‘instability’, ‘hedging’, and ‘derivatives’ to inspire awe and trust among those who discuss these activities with you. Of utmost importance to Step Two, one must invest in only certain types of products to assure that one’s portfolio remains inflexible and susceptible to crashing.
The deregulation of derivatives in large banks was a big cause to the financial crisis. Derivatives are a contract between two or more parties that are based on the fluctuation of an underlying asset such as stocks, bonds, currencies, and interest rates. These derivatives are also very complicated. Amadeo (2018) wrote a post that included the statement “In 1999, the Gramm-Leach-Bliley
The intention of this essay is to provide an in depth and critical analysis of the financial crisis that took place between 2007-2009, in particular focusing on some key issues raised by the Foote, Gerardi and Willen paper ‘Why did so many people make so many Ex Post bad decisions?’ Whilst there were many contributing factors, it is clear that a specific few played a particularly dominant role, primarily the ‘Bubble Theory’, irresponsible regulation, toxic CDO’s and $62 trillion of CDS’s.
In 2008, it was targeted on the executives at big investment banks who created incredible derivatives from worthless mortgages. According to the mentioned above theory, the result of each meltdown should be better than the last time one under continuously severe regulation and policies after punishing these culprits. However, the economic crashes consistently to happen with the increased level of damage and high frequency after punishing these villains. Look back upon these tragedies happened in the economy, Martin pointed out the main reason hidden in the issue and answered this questions in this book. Martin believed that people now failed to catch the real and fundamental reasons caused those economic crashes and bubbles, which is only a matter of time. In the point of Martin’s view, he thought theories about the fundamental goal of corporations and the optimal structure of executive compensation are fatally flawed and have created panic in the stock market. Thus Martin thought that the only way we could avoid increasingly frequent stock market meltdowns with pain, suffering and economic disorder they cause is to explore the better and new theories to strengthen the system of American capitalism (Martin, p.g10).
What is different today? In 2015, the stock market rose 20% higher than its 2008 peak while the derivatives exposure of the top 9 banks over the same period has risen at 40%-twice that rate from $160 trillion to more than $228 trillion. Over the past couple of decades, the derivatives market has multiplied in size because it is one of the few areas the government has not heavily regulated. Everything is going to remain fine as long as the system stays in balance. But when markets become rapidly unstable, we could witness a string of financial crashes that no government on earth will be able to
In 2006, Lehman Brothers Holdings Inc., was allowing employees to trade derivatives. Derivatives, are an agreement or contract that represents a determined value of something. These derivatives can be put in any security, a document that represents a share in a company or a debt owed by a company. Employees of the firm were trading significant sums of money. An intern, only a junior in college, was given $150 million to trade.39 A junior trader in the firm was given $450 million. The firm invested primarily in real estate, derivatives, and bonds. Bonds are a promise to repay a principal amount plus interest, raising the firm’s capital by borrowing. When the financial crisis reached a peak in 2008, and the market crashed, the credit markets seized up, and people were no longer borrowing money. The reported loss for Lehman was $32 billion from proprietary trading and principal transactions that had taken place a year and a half
Many banks were taking on huge risks increasing their exposure to problems. Perhaps it was ironic, as Evan Davies observed, that a financial instrument to reduce risk and help lend more—securities—would backfire so much.
Financial market instruments are essential for hedging the occurring risks of business corporations. There is a large market for financial instruments, such as the derivatives that are used to hedge commodities, currencies, equities and interest rates. World-exchanges (2014) reports about a total amount of 22 Billion of Exchange Traded Derivatives contracts being in the market in 2013. This essay attempts to determine the present risks by analysing the production cycle of a salmon farming company, Loch Duart and to provide the possibilities to hedge these risk using derivatives.
This essay looks at two articles which were written within the last three months about reforms that are being made to the United States financial system. The first article is a review of news from Secretary Geithner that the United States is close to making some real reforms. He talked specifically about hedge funds and risk-taking within the banking system in general (Reuters, 2012). The second article discussed the issues that are present with Fannie Mae and Freddie Mac, how both sides of the aisle want to dismantle them, and the inherent problems in doing so (Chadbourn, 2012). The comments from readers of the two articles were specific, and for the most part, showed some intelligent discussion.
Higher use of derivatives corresponds to greater systematic risk, there is a positive relationship between the derivatives and risk in trading as well as hedging. The figures below shows that this positive relationship is stronger for the large business holding companies (BHC) than for small BHC. This indicates that the large BCH with operations in brokerage, asset management and trading primarily uses derivatives to derive their gains further exposing them to systematic risk. The small BCH results indicate that they use derivative to a larger extent to hedge against the systematic risk.
However, with the passage of time, people’s understanding of the role of financial derivatives gradually deepening, hedge funds in recent years, favoured because hedge funds have the ability to make money in the bear market. From 1990 to 2002, ordinary public funds lost an average of 11.7 per cent a year, while hedge funds earned 11.2 per cent a year during the same periods. There are some reasons for hedge funds which got such impressive results in surveys, and the benefits they receive are not as easy as the outside, and almost all hedge fund managers are excellent financial brokers.
A startling example given by Charles Ferguson is that of the derivatives market. The high risks that began with subprime lending were transferred from investors to other investors who, due to questionable rating practices, falsely believed that the investments were safe. And these rating were done by Academicians-Consultants who were given millions of dollars for these false ratings. On being questioned by the law about the validity and basis for those ratings, the only answer which was given was that at that time they believed (or were made to believe) that those investments were good. Due to these false ratings the lenders were pushed to sign up mortgages without regard to risk, or even favoring higher interest rate loans, since, once these mortgages were packaged together, the risk was disguised. According to the film, the resulting products would often have AAA ratings, equal to U.S. government bonds. The products could then be used even by investors such as retirement funds which
According to the work examined in this study the global recession that occurred in 2008 and 2009 was partially a result of the financial industry's failure to be responsible for the decision it made in using financial instruments that were risk and very complex in nature. The culture of corporations were constructed on risk-based rewards instead of rewards that resulted in value for stakeholders. The financial risks that banks took on were not well comprehended by the public or regulators and the mass media also failed to understand the risks that the banks had entered into with certain financial agreements.