Derivatives : Financial Weapons Of Mass Destruction

Derivative contracts were either negotiated with specific counterparties (over-the-counter) or were standardized contracts executed and traded on an exchange. Negotiated over-the-counter derivatives were comprised of forwards, swaps, and specialized options contracts. Over the counter derivatives can be tailored to meet the customers’ needs with respect to time and quantity and they are not traded in an organized exchange. On the other hand, standardized exchange-traded derivatives consisted of futures and options contracts. Even though over-the-counter derivatives were usually not traded like securities in an exchange, they might be terminated or assigned to an alternative counterparty. Standardized derivatives trade on an exchange and have time and quantity that are fixed.

Analyze the derivatives market and determine the use of derivatives to efficiently manage investment risks in an investment portfolio.

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.

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.

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 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

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).

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

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.

Nestlé S.A. is a Swiss company and owns a prestigious position being the world’s leading nutrition, health and wellness group (Nestlé, 2016). According to its annual report (2015), this company is exposed to many risks caused by movements in foreign currency exchange rates, interest rate and market prices. The foreign exchange risk comes from transactions and translations of foreign operations in Swiss Francs (CHF). The interest rate risk faces the borrowings at fixed and variable rates. The market price risk comes from commodity price and equity price. The former risk arises from world commodity market for the supplies of coffee, cocoa beans, sugar and others. The later risk arises from the fluctuations of the prices of investments held. (Nestle annual reports, 2015). Thus, financial derivatives instruments are used by this multinational corporation in order to hedge these risks.

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.

Hedging is a significant measure of financial risk management. Since the 1970s, the increasing number of powerful companies started to control the risk of the exchange rate, the interest rate and commodity by using financial derivatives. ISDA (2013) based on the Global 500 Annual Report 2012 survey found that 88 percent of companies use foreign exchange derivatives. Modigliani & Miller (1958) believed that if the financial markets were under perfect conditions, for instance, there was no agency costs, asymmetric information, taxes and transaction costs, hedging would not increase the company 's value because investors can hedge by themselves. However, a large number of practical studies have shown that hedging is beneficial

Derivatives may be traded either via an exchange (exchange traded) or alternatively, privately negotiated contracts, which are generally alluded to as Over The Counter (OTC) derivatives. Exchange traded and OTC-cleared derivative contracts have downgraded Macquarie’s credit risk as their counterparty is a clearing house, accountable for the handling of risk management for their members to guarantee that the clearing house has sufficient resources to carry out its upcoming obligations. Members are instructed to produce initial margins in agreement with the exchange rules in the form of cash or securities, and further present daily variation margins in cash to cover adjustments in values of the market. Macquarie has exchange traded derivatives with positive replacement values as at 31 March 2016 of $1,794 million, whereas as at 31 March 2016 of $4,641 million.