The Counter Derivatives : Hedging Or Creating Risk?

Investment on securities such as shares, debentures, bonds are profitable as well as exciting. It is indeed rewarding but involves a great deal of risk. Shapiro (2006) describes the emergence and growth of the market for derivative instruments can be traced back to the willingness of risk averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. Kawaller, the President of Kawaller & Company, LLC and Managing Director of the Kawaller Fund in Brooklyn, NY (2008) analysed the prevailing scenario and stated that currency risk is an inherent aspect of international commerce. Fortunately, for enterprises that function in this space-particularly for those that transact with counterparties

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.

“Over-the-counter derivatives will be required to be traded on regulated exchanges, and the trades will have to be submitted to regulated clearinghouses” (First Data Corporation, 2010). The clearinghouses must also submit proposals to the regulators before accepting swaps for clearing. Regulators will have the authority to impose capital, margin, reporting, record-keeping and code of conduct requirements on swap dealers and participants to ensure there are adequate financial resources to meet their responsibilities (First Data Corporation, 2010).

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

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

As noted in section 17, Air Canada uses derivative instruments to provide economic hedges to mitigate certain risks. The valuation include all factors which will be considered in setting a price, such as Air Canada’s and the counterpart’s respective credit risks.

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

their series of transactions will enter in a CCP for OTC markets. There is an uncertain risk that the buyer will default on such transaction. There is also a big risk that the seller of a derivative is not selling in good faith as underlying assets came from complex structures that could clash losses against each other. For these cases, it is better to have a CCP framework in place to strengthen the gaps and circumstances that each parties can take opportunities out of technical aspects such as collaterals, rates and margins. Since CCP intends to regulate such OTC markets by giving enough criteria for trades to take place; collateral management and margining are now surfacing into the picture. These items will set boundaries and reduce counterparty risk, placing trades into an exchange, reducing margins during the process, and simplify the approach for trades. The results of regulation will further define specific rules like types of collaterals to be accepted, risk models, and certain policies on cash collateral, etc. Margins will also play part of regulating the actual initial and variation margins, which affects the movement of mark-to-markets that will improve control on sudden hike of trades at once. So now overall, CCP can help manage and control counterparty risks, prevent derivatives especially OTCs to have over or under collateralization and with a sense of marginal controls to prevent suspicious and abusive transactions to take place on security markets that are not so much regulated by

The real readers for Muhtaseb’s article align very well with his intended readers because of the location of the publication in the Journal of Derivatives and Hedge Funds which caters to financially savvy and hedge fund interested readers. In the second sentence of the abstract, Muhtaseb already begins to reference technical financial terms that his intended reader should understand. When elaborating on how his purpose is achieved, he says, “It is accomplished through identification and analysis of numerous activities normally associated with hedge funds that have become an integral part of capital market activities” (1). Even in the abstract when Muhtaseb attempts to summarize his argument in approachable and concise terms, he uses the phrase ‘capital market activities.’ The intended audience reading in the Journal of Derivatives and Hedge Funds would recognize capital markets as markets for buying and selling debt and equity instruments, but because I am not part of the intended audience for article, I rely on google searches to fill the gaps in my understanding. Because Muhtaseb published his article in a technical journal, though, his real readers are likely

(Lecture 2, Law of Commerce, Investment and Banking). For example, Martin Wolf wrote in 2009: "...an enormous part of what banks did in the early part of this decade – the off-balance-sheet vehicles, the derivatives and the 'shadow banking system ' itself – was to find a way round regulation." (Wolf M., 2009). Off balance sheet financing made it possible for firms to look less leveraged and allowed them to borrow at cheaper rates. (Simkovic M., 2009). Analysis by the Federal Reserve Bank of New York showed that big banks hide their risk levels just prior to opening data quarterly to the public. (Kelly K., McGinty T., Fitzpatrick D., 2010). From this moment it is possible to ask the question: What did regulators do at that moment? Critics have argued that the regulatory framework did not keep pace with financial innovation, such as the increasing importance of the shadow banking system, derivatives and off-balance sheet financing. In other cases, laws were changed or enforcement weakened in parts of the financial system. Several critics have argued that the most critical role for regulation is to make sure that financial institutions have the ability or capital to deliver on their commitments. Another critics have also noted de facto deregulation through a shift in market share toward the least regulated portions of the mortgage market. (Simkovic M., 2011). In overall, regulatory system makes bad impression as it seems not working properly. Author Roger

Derivatives are financial instruments whose values are derived from interest rates, foreign exchange rates, financial indices or other underlying notional amounts. Derivatives are carried at fair value on the consolidated balance sheets in derivative assets or derivative liabilities. We elect to present any derivatives subject to master netting provisions as a gross asset or liability and gross of collateral. Disclosures regarding balance sheet presentation of derivatives subject to master netting agreements are discussed in Note 3 – Derivative Instruments. We may designate derivatives as cash flow or fair value hedges.

w how transactions in derivative instruments can be used to either hedge risks or to open speculative positions.

A hedge fund is a regulated investment fund that is typically open to a limited range of investors who pay a performance fee to the fund’s investment manager. Every hedge fund has its own investment philosophy that determines the type of investments made and strategies employed. In general, the hedge fund community undertakes a much wider range of investment and trading activities than traditional long-only investment funds. Hedge funds invest in a broader range of assets, including long and short positions in equity, bonds, commodities, and derivatives. Hedging out unwanted risk has been a common activity in the financial markets for centuries. In the 1800s, for example, commodity producers and merchants started using forward contracts to protect themselves against futures changes in commodity prices—these contracts hedged out the risk of adverse market fluctuations beyond their control. Such forward contracts are still traded to this day in the futures market. Alfred Jones is credited with the creation of the term “Hedge Fund” in 1949. He created A.W. Jones, a partnership with four friends, and through this vehicle he invested $100,000 in stocks, using both long and short positions. During the first year, the fund returned 17.3%. The idea has caught fire since.

There are many different types of derivative instruments that can be used in financial markets. This paper will examine the various different types of futures contracts, (futures) that are available to be purchased in the marketplace. It will be shown what role they play in managing risk with multinational companies, portfolio managers, and institutional investors alike. It will also be touched on about how speculators can find opportunities for financial gain with the use of futures.

To understand how this debacle came about, one must have a basic understanding of the nature of a derivative and what they are designed to do. Initially, derivatives were designed to provide an investor/trader with a type of insurance against unexpected movements in prices which could devastate an investment portfolio. These derivatives take the form of futures and options: