Risks and Benefits of Derivative Contracts - Coursework Example

Risks and Benefits of Derivative Contracts Introduction Derivatives securities have been used by banks to generate profits that are functions of the changes in price of the underlying assets. Investment managers and banks use derivatives to enhance better utilization of information, management of risks and reduction of the transaction costs. Contrary, the recent press publication portrays derivatives as high risk and speculative investments. The public concern has prompted re-evaluation of the risk disclosure requirements by Securities and Exchange Commission of the mutual funds as well as to provoke the possible regulatory initiatives (Franklin & Michael 1995, p. 211-264). The recent publicised bankruptcies by the Orange County and the British Investment house of Barings purportedly relates to losses from speculative positions in different derivative securities that caused a flurry of discussion, which questioned the derivative investment. There have been several investor lawsuits on losses from derivatives. For instance, in MG trading subsidiary, in United States, in 1993, there were large derivatives positions in futures and swaps in energy. Instead of the prices rising, they sharply fell in late 1993. The company incurred unrealized losses with the derivatives having margin excesses of $900 million. The press reports indicated that the predicament was as a result of the massive speculation in the energy futures and off-exchange. However, not all the press reports hold on to this; others believe that derivatives in MGRM activities were as a result of complex oil hedging and marketing strategy. Negotiation for most of forward delivery contracts happened in summer of 1993, when prices for the energy were falling. The end-users took advantage of locking-in the low energy prices for the future, and the company benefited through developing profitable customer relationship (Carr & Dilip 2001, p. 33-59). The large financial losses from the money market funds increased the public concern on derivative investment. There are hot discussions about regulation of the derivative investment. Most of the negative publicity on derivatives reflected by the popular press is partial contrast to the theoretical arguments on benefits of derivatives. This questions the recent concerns on the risks from derivatives since derivatives have a high likelihood of reducing risks for the financial institutions (Carr & Dilip 2001, p. 33-59). Benefits and risks of derivative contracts A derivative entails the transaction whose value is derived from the value of the underlying assets. A derivative contract refers to a financial contract that has a value derived from the value of the underlying assets, indices of assets or other credit related events. Examples of derivative contracts are the credit contracts, foreign exchange rate and interest rate among others. Derivative contracts have in the past years shown extraordinary growth. Nevertheless, certain events raise questions on the risks that are associated with derivatives. The large losses realized from the use of the derivative contracts have increased fear among many market participants (Chatrath & Rohan 2004, p. 58-72). Derivative trading is being considered as a risky activity that causes a widespread disruption of the financial system. Most discussions on derivative-related losses ignore the benefits of the benefit contracts to the economy at large. Derivative contracts provide firms with opportunities otherwise not available. The derivative contracts are critical in allocating risks across firms and investors where they reduce the costs for the diversifying portfolios. The risks associated with derivative contracts depend on the utilization of contracts in market settings. The contracts entail the legal risks where one party to the contract default and this risks the credit. Problems may arise on liquidity of the derivative or the ease of trading (Chatrath & Rohan 2004, p. 58-72). Benefits of derivative contracts Derivative contracts have three key benefits. They enhance market completion and risk sharing, help in implementation of the decisions on asset allocation and enhances information gathering. In risk sharing, derivatives provide an efficient allocation of the economic risks. The state-preference model is used in describing the risk sharing benefits of the derivatives. According to this framework, derivatives are effective in enhancing the tremendous power of the capital markets. The framework characterises the risks through the distribution of the payoffs and risk allocation is based on the allocation of portfolios of the state securities. Derivatives ensure unconstrained trading in order to achieve desirable allocation of risks in terms of distribution of the pay-offs. The implementation of the strategies by the derivatives is enhanced where the static strategy enables the achievement of the payoffs. The static strategies indicate the buy-and-hold investment in derivatives. These strategies can be easily implemented to enhance cheap diversification and leveraging of the opportunities (Gregoriou 2006, p. 180-81). Derivatives are significant in reducing the diversification and leveraging costs. This is because they are available on aggregate risk factors like the stock portfolios and the global bond that has many future and global risk positions. Derivatives facilitate diversification also because the investment represents a fraction of the cash instrument and hence easier to diversify the capital on several assets. Leveraging of opportunities in cash markets is quite hard, but futures and options represent levered investments for the underlying cash instruments. The levered investments are economically beneficial in terms of efficient risk allocation and market completeness. In information gathering, derivatives enhance implementation of the portfolio strategies. For a perfect market without the transaction costs, friction and informational symmetry contains no benefits derived from used of derivative instruments. Nevertheless, in the presence of market illiquidity and trading costs, the portfolio strategies can be supplemented or implemented with the derivatives at substantially lower costs. As a result, welfare effect of the derivative instrument arises from reduced transaction costs. When risk allocation forms the main component of the instrument, the derivative markets will affect the informational structure of the financial system. Information structure is critical in determining the dynamics and stability of an economic system. Substantial portion of the discussions about stability of the derivative markets incorporates the information effects. However, the traditional analysis of derivatives ignores the informational role of the asset markets. When the market moves at a faster rate than expected, the occurrence of dynamic adjustment might be too late. The success of dynamic trade depends on the use of pro-cyclical strategy by investors, normally using stocks and cash (Gregoriou 2006, p. 180-81). Economic benefits of the information can be illustrated using the stock market crash of 1987. If only the investors knew the volume of institutional assets that were dynamically managed, they would have avoided the same strategy or used the reverse strategy. If the same strategies were implemented, the potential imbalance would have been easily viewed using the high implied volatilities. Insurance would be extremely costly for the creation of strong incentive for the writing options. Derivatives are critical in circumventing the informational externalities based on the imperfect information. The liquidity in the market is highly related to the information externalities (Lhabitant 2009, p. 86-87). Risks associated with derivative contracts The major pre-occupation of banks, regulatory bodies and the other market participants have essentially gravitated over the recent years around identifying the qualitative appreciation of the risks associated with the derivative contracts. More specifically is the delicate causality debate on the relationship between instability in economic fundamentals and increased volume of derivative trading (Östermark 2011, p. 281-90). Categories of Risks The risks associated with the derivative contracts are in three principal categories. These include the explicit risks which contains the different market exposures that result from pure position or service by the derivative contract. Explicit risk stems from allocation of the risk function by the derivative contracts in a perfect market scenario. For instance, the CBOE T-Bond has a high degree of liquidity and abstract from credit exposure. The derivative contracts are redundant assets in a perfect market setting, and they cannot affect return characteristics or price of the underlying cash instrument in any way. Derivative contracts can only reallocate the inherent market risks across the participants in the market (Östermark 2011, p. 281-90). The second category is the implicit or structural risks. It comprises all the risks in the use of the derivative within a specific economic environment. This category recognizes the existence of market frictions and the comparative advantages of the categories of institutions and agents. Example is the credit risk exposure which arises from particular derivative contracts, and can vary from zero onwards. For instance, for an index option from a low credit intermediary is affected by explicit risks. When the same contract is from a CBOE, it is affected by explicit risks. The former, the one with implicit risks, trades at relatively low price despite the equal specifications of the contract. This reflects implicit embedment of the default risk discount. The third category is the estimation or perceived risks. These arise from imperfect information within the financial markets and the imperfect ability of assessment and interpretation of the end-user derivatives and the financial markets by the market participants. The perception of the risks depends on the market transparency and information disclosure, lack of educational training for the market participants, and the adverse risk incentives which are provided by the players in the market using appropriate compensation schemes. All the three categories of risks can be reduced or amplified through measurements and estimations. The fourth category is the perceived risk that comprises accounting risks, educational risks and disclosure risks. The level of education and information offered to the market participants in order to impact on their perception of the existing risks. From the analysis of the above categories of risks, the explicit risks are associated with the derivative contracts, and they result from the redistribution of market risks that are inherent in underlying their cash instruments based on zero sum game. The structural and estimation risk categories originate from the choices in institutional markets. The uncertainties in accounting, settlement and credit and disclosure risks are neither specific to nor created by the business derivatives. Issuing of the primary securities is affected by the informational asymmetries, and they partially reflect the under-pricing of the seasoned offerings and the illiquidity of durable goods and housing markets (Östermark 2011, p. 281-90). Analysis of Main Risks Market risk Market risks are measured by volatility of the underlying factor relative to changes in price. The risk attributes of derivative contract can be translated directly into respective cash equivalent, interest rate or other risk exposure in the global market. This is done using rho, delta and gamma factors. Actual and target risk exposure are based on the assumption of accurate specification of the pricing model. The theoretical problems also arise due to difficulties in accounting for correlations. Ignorance of correlation affects the financial institutions because of the costly overhedged positions (Ridley 2005, p. 94-95). Credit Risk This refers to the loss incurred on derivative contract if the counterpart fails in honouring the engagement. The risk is caused by the problems in measurement of the default risk due to the absence of robust measurement technology for the risk. However, appreciation of the credit risk is subjective and qualitative in nature (Ridley 2005, p. 94-95). Liquidity Risks Liquidity refers to facility whose specific financial instrument can be measured based on time and costs, and can be traded. Illiquidity results from market frictions that induce lags and leads in the low of orders by an investor. The liquidity risks entail structural and perceived components, but it is primarily a component of structural risk category (Ridley 2005, p. 94-95). References List Carr, P., & Dilip, B. (2001). Optimal Investment in Derivative Securities, Finance and Stochastics 5(1), pp. 33-59. Chatrath, A., & Rohan, C. (2004). Futures Expiration, Contract Switching, and Price Discovery, The Journal of Derivatives 12(1), pp. 58-72. Franklin, R., & Michael, S. (1995). The Collapse of Metallgesellschaft:Unhedgeable Markets, Poor Hedging Strategy or Just Bad Lack? Journal of Future Markets 15(3), pp. 211-264. Gregoriou, G. N. (2006). Hedge Fund and Investment Management, Derivatives Use, Trading & Regulation 12(1), pp. 180-181. Lhabitant, F. (2009). The Encyclopedia of Alternative Investments, Journal of Derivatives & Hedge Funds 15(1), pp. 86-87. Östermark, R. (2011). A Short Note on the Growth Potential of Risky Fund Investments, Journal of Derivatives & Hedge Funds 17(4), pp. 281-290. Ridley, M. (2005). How to Invest in Hedge Funds: An Investment Professionals Guide, Derivatives Use, Trading & Regulation 11(1), pp. 94-95. Read More