Disadvantages Of Derivatives Markets

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

Mr. Brown readily admitted that he was not at ease discussing the most recent approaches to risk reduction or hedging. He had received his MBA from Harvard in the 1960s and had spent most of his career working for a company that had little international exposure. Moreover, he was not familiar with derivatives such as currency options, which until recently were not widely traded. However, Mr. Brown had recently hired an assistant, Mr. Dan Pross, who had some knowledge of hedging and derivatives. As a student at UCLA, Mr. Pross had traded various types of derivatives for his own portfolio and was familiar with how they were traded. Although Mr. Pross did not have a finance background, he was, in Mr. Brown’s opinion, extremely intelligent and highly capable. Mr. Brown suggested that Mr. Pross make a presentation to the senior management on the use of derivatives to reduce risk.

To help make them more transparent, a clearinghouse of sorts— similar to the stock exchange—must be set up so these derivative trades can be transacted in public. But Dodd-Frank left it up to the regulators to determine exactly the best way to put this clearinghouse into place. And not all derivatives will be subject to the law. The Securities and Exchange Commission and the Commodity Futures Trading Commission approved a rule that would exempt some energy companies, hedge funds and banks from derivative oversight.

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.

The years 2008 shined a light on a group of people who were considered high society. When the stock market crashed in September 2008, the world shines a spotlight on the financial corporation. Words such as hedge fund manager and financial instrument such as credit default swaps are not words not known to everyday citizens. The economic downturn forced society to ask question not normally asked.

The definition of "derivatives" is also very wide, and includes options and warrants, whoever they are issued by, as well as rights and interests in respect of listed securities (or other derivatives).

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

In the early 1990s derivatives were put in place, these instruments are basically speculation or betting on stock prices, bankruptcy of companies, interest rates etc. In the early 2000 they passed a law that made derivatives unregulated so the market boomed in 2001. All these laws passed were rational choices being made by individuals they realized they can make money. They were acting out of their own self-interest and no one else. Millions of Americans lost their homes in the crash due to these subprime loans that were put in place by these big banks.

1(a) Financial System is a complex yet connected system that consist of financial intermediaries, financial institutions and financial assets.

Most firms hedge at least some of their risks. Hedging can take two basic forms—namely, natural hedging and hedging by means of derivative instruments. The use of derivatives as hedges has expanded greatly in recent years.

Introduction 1 Introduction to derivatives 2 Introduction to forwards and options vii 1 7 29 79 129 141

Derivatives are financial contracts whose price is either linked to the price of an underlying asset, commodity, rate, index or the occurrence or significance of a certain event. The phrase derivative originated from how the price of these contracts is derived from the price of some underlying commodity, security or index or the magnitude of an event. The set of financial instruments that include futures, forwards, options and swaps are referred to by the term Derivative. A derivative can be combined with a security or loan which will be then called a hybrid instrument or alternatively a structured security and structured financing. (Dodd, R., 2002).

Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position.

Economic derivatives could be so unsafe that they could even a great cause of financial disasters. This is because many investors turn to financial derivatives market to direct them into future funding, rather than of observing at the genuine market. This can lead to market distortions and hence can be extended to other parties of the market connected in the market and thus financial position of a country can be obstructed badly. Derivative instruments were created after 1970s as a way to manage risk and create insurance downside. They were created in response to the frequent oil market shocks, inflation and drops in the stock markets. Hence the initial intend was to defend against the risk and protect against the downside. However, the derivatives became speculative tools often used to take more risk in order to maximize profits and returns. Derivatives do ensure against the risk when used properly, but when the packaged instruments became too complicated that neither the borrowers nor the rating agencies understood them or their risk and hence the initial premise just failed. Not only did investors, like pension fund, got stuck holding securities that in reality turned out to be equally as risky as holding the underlying loans, bank got stuck as well. Banks held many of these instruments on their books as a source of fixed income requirements and hence using these derivatives instruments as a collateral. However, later it was found out that they had less

According to Goel and Gutierrez, they investigated that fluctuating procurement price is one of the causes of inventory risk and through trading appropriate numbers of futures or forward commodity contracts reduces inventory related costs for effective hedging. Hedging and the price discovery functions of futures markets facilitates not only a better inventory management but enhances the efficiency of marketing operations, production and storage.