95189683 Derivative Markets

7/30/2019 95189683 Derivative Markets

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INSTITUTE OF BUSINESS & TECHNOLOGY

I. INTRODUCTION

Derivative markets are investment markets that are geared toward the buying

and selling of derivatives.

I.i. What are Derivatives?

Derivatives are financial contracts that are designed to create market price

exposure to changes in an underlying commodity, asset or event. In general they

do not involve the exchange or transfer of principal or title. Rather their purpose is

to capture, in the form of price changes, some underlying price change or event.

In other words Derivatives are securities, or financial instruments, that get their

value, or at least part of their value, from the value of another security, which iscalled the underlier. The underlier can come in many forms including,

commodities, mortgages, stocks, bonds, or currency. The reason investors may

invest in a derivative security is to hedge their bet. By investing in something

based on a more stable underlier, the investor is assuming less risk than if he

invested in a risky security without an underlier.

The term derivative refers to how the prices of these contracts are derived from

the price of some underlying security or commodity or from some index, interest

rate, exchange rate or event.

Examples of derivatives include futures, forwards, options and swaps, and these

can be combined with each other or traditional securities and loans in order to

create hybrid instruments or structured securities.

I.ii. Historical Background:

As a testament to their usefulness, derivatives have played a role in commerce

and finance for thousands of years. The first known instance of derivatives

trading dates to 2000 B.C. when merchants, in what is now called Bahrain Islandin the Arab Gulf, made consignment transactions for goods to be sold in India.

A more literary reference comes some 2,350 years ago from Aristotle who

discussed a case of market manipulation through the use of derivatives on olive

oil press capacity in Chapter 9 of his Politics.

II. FORMS OF DERIVATIVE MARKETS

BUSINESS FINANCE I (FIN 201) Fall 2010 DERIVATIVE MARKETS 1


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There are actually two distinct forms of the derivative market. It is possible to

purchase and sell derivatives in the form of futures or as over-the-counter

offerings. Derivatives are traded on derivatives exchanges, such as the Chicago

Mercantile Exchange (CME) which employs both open outcry in "pits" andelectronic order matching systems, and in over-the-counter markets where

trading is usually centered around a few dealers and conducted over the phone

or electronic messages. It is not unusual for investors who are interested in

derivatives to actively participate in both of these financial markets.

Derivatives can be considered as providing a form of insurance in Hedging,

which is itself a technique that attempts to reduce risk.

Derivatives allow risk related to the price of the underlying asset to be transferred

from one party to another. For example, a wheat farmer and a miller could sign a

futures contract to exchange a specified amount of cash for a specified amount

of wheat in the future. Both parties have reduced a future risk: for the wheat

farmer, the uncertainty of the price, and for the miller, the availability of wheat.

However, there is still the risk that no wheat will be available because of events

unspecified by the contract, such as the weather, or that one party will renege on

the contract. Although a third party, called a clearing house, insures a futures

contract, not all derivatives are insured against counter-party risk.

II.i. Future Markets:

In the case of futures, there are futures markets around the world that allow

trading that involves derivative contracts. In this type of financial market

environment, the exchange functions as a counterparty to members engaged in

buying and selling activity.

The process for investing in futures in a derivative market works by establishing a

situation where one party sells one futures contract while the counterparty

purchases a new futures contract. The result of the two transactions effectivelyproduces a position that is considered to be at zero. This approach essentially

transfers the bulk of the risk to the counterparty in the arrangement and makes it

possible to earn a return by exchanging a long position for a short one.

II.ii. Over-The-Counter (OTC) Markets:

http://www.wisegeek.com/what-are-futures.htmhttp://www.wisegeek.com/what-are-futures.htm


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A derivative market situation may also exist in over-the-counter or OTC markets.

In this scenario, the derivatives focus on larger clients such as government

entities, investment banks and hedge funds. Trading on these markets can

involve several different types of options, including credit derivatives. The volumeof the trading activity is substantial, involving significant amounts of resources on

the part of the investors involved.

The size of derivatives markets is enormous, and by some measures it exceeds

that for bank lending, securities and insurance. Data collected by the Bank of

International Settlements (BIS) show that the amounts outstanding in the over-

the-counter (OTC) market and those at derivatives exchanges have exceeded

billions of US dollars.



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III. ADVANTAGES AND DISADVANTAGES OF DERIVATIVES

Today, derivatives are used to hedge the risks normally associated with

commerce and finance.

III.i. Advantages:

Farmers can use derivatives the hedge the risk that the price of their crops

fall before they are harvested and brought to the market.

Banks can use derivatives to reduce the risk that the short-term interest

rates they pay to their depositors will raise and reduce the profit they earn

on fixed interest rate loans and securities.

Mortgage giants Fannie Mae and Freddie Mac the world largest end-

users of derivatives use interest rate swaps, options and swaptions to

hedge against the prepayment risk associated with home mortgage

financing.

Electricity producers hedge against unseasonable changes in the weather.

Pension funds use derivatives to hedge against large drops in the value of

their portfolios.

Insurance companies sell credit protection to banks and securities firms

through the use of credit derivatives.

In addition to risk management, derivatives markets play a very useful economic

role in price discovery. Price discovery is the way in which a market establishes

the price or prices for items traded in that market, and then disseminates those

prices as information throughout the market and the economy as a whole. In this

way market prices are important not just to those buying and selling but also

those producing and consuming in other markets and in other locations and all

those affected by commodity and security price levels, exchange rates and

interest rates.



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The use of derivatives also has its other benefits:

Derivatives facilitate the buying and selling of risk and many people

consider this to have a positive impact on the economic system. Althoughsomeone loses money while someone else gains money with a derivative,

under normal circumstances, trading in derivatives should not adversely

affect the economic system because it is not zero-sum in utility.

Former Federal Reserve Board chairman Alan Greenspan commented in

2003 that he believed that the use of derivatives has softened the impact

of the economic downturn at the beginning of the 21st century.

III.ii. Disadvantages:

Derivatives play a useful and important role in hedging and risk management, but

they also pose several dangers to the stability of financial markets and thereby

the overall economy.

Along with these economic benefits come costs or potential economic costs. As

an indication of the dangers they pose, it is worthwhile recalling a shortened list

of recent disasters.

Long-Term Capital Management collapsed with $1.4 trillion in derivatives

on their books. In the process it froze up the U.S dollar fixed income

market.

Sumitomo Bank in Japan used derivatives in their manipulation of the

global copper market in the mid-1990s.

Barings Bank, one of the oldest in Europe, was quickly brought to

bankruptcy by over a billion dollars in losses from derivatives trading.

Derivatives dealer Enron collapsed in 2001 the large bankruptcy in US

history at the time and caused collateral damage throughout the energy

sector. In the process it was disclosed how Enron and other energy

merchant, i.e. energy derivatives dealers, used derivatives to manipulate

electricity and gas markets during California's energy crisis.



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The use of derivatives for tax evasion was also brought to light.

In 2002, the Allied Irish Bank's Allfirst lost $750 million trading in foreign

exchange options.

Both the Mexican financial crisis in 1994 and the East Asian financial crisis

of 1997 were exacerbated by the use of derivatives to take large positions

involving the exchange rate.

Criticism:

Derivatives are often subject to the following criticisms:

Possible large losses

The use of derivatives can result in large losses because of the use of

leverage, or borrowing. Derivatives allow investors to earn large returns from

small movements in the underlying asset's price. However, investors could

lose large amounts if the price of the underlying moves against them

significantly. There have been several instances of massive losses in

derivative markets, such as:

The need to recapitalize insurer American International

Group (AIG) with US$85 billion of debt provided by the US federal

government. An AIG subsidiary had lost more than US$18 billion

over the preceding three quarters on Credit Default Swaps (CDS) it

had written. It was reported that the recapitalization was necessary

because further losses were foreseeable over the next few

quarters.

The loss of US$7.2 Billion by Socit Gnrale in January

2008 through misuse of futures contracts.

The loss of US$6.4 billion in the failed fund Amaranth

Advisors, which was long natural gas in September 2006 when the

price plummeted.

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The loss of US$1.3 billion equivalent in oil derivatives in

1993 and 1994 by Metallgesellschaft AG.

Counter-party risk

Some derivatives (especially swaps) expose investors to counter-party risk.

For example, suppose a person wanting a fixed interest rate loan for his

business, but finding that banks only offer variable rates, swaps payments

with another business who wants a variable rate, synthetically creating a fixed

rate for the person. However, if the second business goes bankrupt, it can't

pay its variable rate and so the first business will lose its fixed rate and will be

paying a variable rate again. If interest rates have increased, it is possible that

the first business may be adversely affected, because it may not be prepared

to pay the higher variable rate.

Different types of derivatives have different levels of counter-party risk. For

example, standardized stock options by law require the party at risk to have a

certain amount deposited with the exchange, showing that they can pay for

any losses; banks that help businesses swap variable for fixed rates on loans

may do credit checks on both parties. However, in private agreements

between two companies, for example, there may not be benchmarks for

performing due diligence and risk analysis.

Large notional value

Derivatives typically have a large notional value. As such, there is the

danger that their use could result in losses that the investor would be unable

to compensate for. The possibility that this could lead to a chain reaction

ensuing in an economic crisis, has been pointed out by famed investor

Warren Buffett in Berkshire Hathaway's 2002 annual report. Buffett called

them 'financial weapons of mass destruction.'The problem with derivatives is

that they control an increasingly larger notional amount of assets and this

may lead to distortions in the real capital and equities markets. Investorsbegin to look at the derivatives markets to make a decision to buy or sell

securities and so what was originally meant to be a market to transfer risk

now becomes a leading indicator.

Leverage of an economy's debt



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Derivatives massively leverage the debt in an economy, making it ever

more difficult for the underlying real economy to service its debt obligations,

thereby curtailing real economic activity, which can cause a recession or even

depression.

Financial Crises of 2007-2010:

The derivative markets have been accused lately for their alleged role in the

financial crisis of 2007-2010. The leveraged operations are said to have

generated an irrational appeal for risk taking, and the lack of clearing

obligations also appeared as very damaging for the balance of the market.



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IV. MAJOR CONCERNS & RECOMMENDATIONS

IV.i. Major Concerns:

The first and most obvious concern is the way in which derivatives

markets expand risk-taking activity relative to capital. By enhancing the

efficiency of transactions and the leveraging of capital, derivatives can

increase speculation just as well as they lower the cost of hedging.

Secondly, derivatives markets can provide new opportunities for

destructive activities such as fraud and manipulation; and they can

facilitate unproductive activities such as outflanking prudential financial

market regulations, manipulating accounting rules and evading or

avoiding taxation.

The third concern involves the creation of new types and levels of

credit risk as OTC derivatives contracts are traded in order to shift

various types of market risk. The new credit risk is not subject to

collateral (i.e. margin) requirements, and is not handled in the most

economically efficient manner.

The fourth concern is the liquidity risk, especially in the interest rate

swaps market, which is susceptible to creditworthiness problems at

one or more of the major market participants.

The last concern is systemic risk, arising especially from the OTC

derivative markets, and the strong linkages between derivatives and

underlying asset and commodity markets



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IV.ii. Recommendations:

Concerning derivatives the recent financial crises has shown us that

guarantee of completion of operations is a goal to achieve, avoiding in

this way counter party risk.

To achieve this goal the settlement & clearing house (derivative

organized markets) has a key role.

Having a settlement & clearing house means a effort of standardization

of products and this is not always possible.

One of the potential implications of this scenario is the potentialcontraction of the size of OTC markets.



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V. CONCLUSION

The appeal of a derivative market has to do with the potential for a larger return

than is usually the case with other forms of investment. In like manner, the ability

to transfer the liability from one party to another is also appealing in somesituations. While it is true that derivatives can be somewhat volatile, the fact is

that many of the trades conducted on a derivative market carry no more risk than

in investment markets. As long as the investor performs due diligence as it

relates to understanding past, current, and projected performance, it is possible

to do very well in a derivatives market.

95189683 Derivative Markets

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