Risk of Derivatives - Essay Example

Are the Risks of Derivatives Manageable? s Are the Risks of Derivatives Manageable? Derivatives are financial instruments (contracts/agreements) which become exercisable on the occurrence or non-occurrence of any specific event. According to Hu (1993), derivatives are the contracts that allow or obligate the user/drawer of the contract to buy or sell the underlying asset at any time in the future at the specified value/price. Hu also explained that changes in the value of the assets also change the value of the said contract.

This underlying asset can be interest rates, exchange rates, stocks, commodities, goods, and so forth (Hu, 1993). Derivatives are either traded in stock markets or can be quickly made or created through any financial institution (including banks). Derivatives are widely used these days by corporate entities and other users in order to manage and control the risks associated with financial transactions and to limit the risks of changes in rates of commodities, interest rates, market conditions, or foreign currency rates.

Derivatives can occur in many forms and types “including futures, forwards, swaps, options, structured debt obligations, and deposits,” (Comptroller of the Currency Administrator of National Banks, 1997, p. 1). These financial instruments produce many risks for the users and both the parties involved (that is, the drawer and the drawee of the derivative contracts). Some of the dangers include the risk of change in the price of the derivative itself, a change in interest rates, and a change in foreign exchange rates, if applicable, to name only a few.

In this paper, the manageability of risks of derivatives, as per the given text, is discussed and evaluated. The ideas of Thomas A. Bass, who considers that the risks of derivatives are manageable are compared and evaluated with the ideas presented by Justin Welby who argues that the risks of derivatives are not controllable.Comparison of the different ideas given by Welby and BassThe management of risks associated with the use of derivatives and the ideas and conclusions of two authors, Bass and Welby, were discussed.

In his article, “The Ethics of Derivatives and Risk Management,” Welby’s view was that the vast use of derivatives in the financial markets these days in order to reduce certain financial risks and control them is itself quite dangerous. However, the risks associated with the derivatives are quite doable with the help of implementing ethical investment policies, including transparency, governance, and so forth. He believed that derivatives are those financial instruments that can be used to “alter the risk profiles” rather than being the financial instruments used for speculation purposes only (Newton, Englehardt, & Pritchard, 2011, p. 136). In the article, Welby also explained that derivatives are very strong and solid financial instruments that, if not properly monitored and if not used under proper control, may cause many risks to the corporation opting to employ these instruments for hedging or risk management purposes (Newton, Englehardt, & Pritchard, 2011).

Therefore, according to Welby, the risks associated with the use of derivatives are quite manageable if appropriate monitoring and control procedures are implemented and effectively carried out. Welby argued that through the principles of transparency (proper assessment and disclosures) and rigid and effective laws governing the use, recording, trading, and disclosures of derivatives, the risks associated with these harmful financial instruments could easily be controlled and managed.On the other hand, Bass in his article, “Derivatives: The Crystal Meth of Finance,” explained and argued that derivatives are a huge risk investment that lead to extensive losses.

One of the examples of such losses is the loss suffered by Warren Buffett in the year 2007, wherein his investments (speculative) in the derivative financial instruments led to a loss of $1.6 billion along with a decline in stock markets and other derivative markets. As per Bass, “Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially harmful” (Newton, Englehardt, & Pritchard, 2011, p. 139). Bass explained that even the controlled implementation of improved transparency cannot help in reducing and controlling the risks associated with the derivatives.

One of the major reasons for this is the complexity and ambiguity of all the derivative transactions that in turn lead to difficulty in assessment and disclosure practices or standardization of processes involved in the management and recording of derivatives. He also argued that the stock markets are neither regulated nor recorded, and so it is quite difficult to determine the size and risks associated with these markets and the traded instruments. But it can be easily said that it is huge and may lead to trillions of dollars in losses if the bearers of the instruments default in payment for any reason.

Therefore, as per Bass, risks caused by derivatives are huge and unwieldy, and derivatives are those difficult and complex financial instruments that lead to huge losses in the form of bad debts for everyone associated with them (Newton, Englehardt, & Pritchard, 2011).Critical AnalysisThe two authors have contradicting opinions about the question of whether the risks involved in financial derivatives can be managed or not. While Bass argues that the risks associated with financial derivatives are not manageable, Welby argues that these risks are manageable.

In Bass’ argument, it is apparent that financial derivatives are dangerous and they should not be applied to use anywhere, as they are capable of vast loses. On the other hand, Welby explains the importance of financial derivatives, and how if appropriately managed, these could be considered assets, in addition to the manageability of their risks. Both authors identify that all financial derivatives come with risks, which require management, just like other financial instruments. However, to an extent, these have addressed financial derivatives as some sort of extra-ordinary financial tools.

When Bass argues that risks associated with derivatives cannot be managed, this to a greater extent reflects a form of ignorance on the overall issue of derivatives. While tackling derivatives, one should approach it as an ordinary financial instrument to avoid coming up with unrealistic assumptions. Bass makes use of the case of Warren Buffett in the year 2007, where investment in financial derivatives resulted in a loss of $1.6 billion, in addition to decline of stock market and derivative markets.

This has been used to add weight to the condemnation he passes on derivatives. On the contrary, this case is one of the most popular cases and has been highly publicized. Such losses are not experienced frequently in all investments in derivatives. By not providing the facts behind the losses, this evidence becomes baseless. Some of the contributory factors to this loss could have been excessive risk-taking, poor management, or lack of clear understanding of the product. Therefore, it is baseless for Bass to blame the nature of derivatives for this loss without giving authentic facts.

Welby on the other hand makes valid opinions about derivatives, when he argues that these can be risk managed if appropriate strategies are employed. This is true because the risks involved with derivatives are not unique from those in other financial tools. The leveling aspect is that, just like the other financial instruments, derivatives also come with risks, and all these need risk-management. Therefore, Welby does well in his argument, as he does not consider derivatives as exotic or extra-ordinary, but accepts the fact that these come with extra risks, which can however, still be managed.

ConclusionThe issue of derivatives raises various concerns, as different people have their own views about derivatives. The varying opinions of Welby and Bass are just a representation of the larger society. This then means that there is no agreement on whether derivatives are useful or not. This is because of the various perceptions of derivatives. While some identify risks associated with derivatives and how these can be addressed and control, others do not address appropriate control tools of the risks.

Nonetheless, different factors led to increased market volatility seen today, and that is why risk-management products were developed. If these products can address the risks in other financial instruments, then why not in derivatives? Regulation therefore, remains the most important instrument for controlling risks in derivatives. In addition, it is important that parties interested in derivatives know the risks involved, then develop management systems that can help in the process of risk management.

ReferencesComptroller of the Currency Administrator of National Banks (1997). Risk management of financial derivatives. [Electronic Version]. The Comptroller’s Handbook. Retrieved from http://www.alcopartners.com/RegulatoryDox/Controller_derivatives.pdfHu, H. T. C. (1993). Misunderstood derivatives: The causes of informational failure and the promise of regulatory incrementalism. [Electronic Version]. The Yale Law Journal, 102(6), 1457–1513. Retrieved from http://www4.gsb.columbia.edu/rt/null?

&exclusive=filemgr.download&file_id=7214615&rtcontentdisposition=filename %3DHenry-Hu-Yale-Law-Journal-Misunderstood-Derivatives.pdfNewton, L., Englehardt, E., & Pritchard, M. (2011). Taking sides: Clashing views in business ethics and society (12th ed.). New York, NY: McGraw-Hill.