Finance and Accounting Financial Services - Essay Example

? Finance and Accounting Financial Services (Derivatives) Table of Contents Table of Contents 2 Inroduction 2 Bank and Companies Exposed to Losses 3 Risk of Derivative Contracts 4 Counterparty Credit Risk 4 Transparency Risk 5 Legal Risk 5 Credit Risk 5 Market Risk 6 Basis Risk 6 Benefits of Derivative Contracts 6 Conclusion 8 Reference 9 Inroduction A derivative contract is referred as a bilateral agreement which grants for payment to be made by one contracting party to the other. The sum of such payment is to be quantified at a future date which is based on index, the value of an asset or rate at that future date. The rate, asset or index, which decides the amount to be paid, is referred as the derivative’s underlying (Cox, 2007, p.77). In United Kingdom, derivatives can be traded by two methods: either through an over-the-counter (OTC) or organised exchange. The exchange traded derivatives market is controlled by Chicago Mercantile Exchange and Euronext.LIFFE that is based in London. Exchange traded derivatives are always bought and sold in an exchange setting that is totally regulated and transparent. On the other hand, OTC exchanges takes place when trader prefer to trade directly with each other. Between both types of trade, there are two main differences: Firstly, exchange traded contracts increases liquidity. Secondly, traders enter into a contract through the exchange clearing house which gives them a guarantee that the contract will be adhered to. Over-the-counter trade do not have that lavishness because there is always the risk that one of the contractors will fail to honour the original agreement thereby going into liquidation (Reid, 2013, p.1). This paper will focus on the list of bank and companies making losses from using derivatives and what are the risks and benefits of different types of derivatives contracts. Bank and Companies Exposed to Losses There are some banks and companies which are exposed to losses due to derivative contracts. Two of the highly publicized and costliest derivatives related losses involve the firms of Barings PLC and Metallgesellschaft AG. The downfall of American International Group Inc (AIG’s) share price, sale of Merill Lynch and Lehman Brothers bankruptcy are other examples which have collectively created a financial atmosphere verging on panic. The financial disorder with its rigorous liquidity and credit crunch seemed to detain to financial markets and institutions in the UK. It resulted in the failure of the key businesses, downturn in the economic activity and reveals a quick drying up of liquidity following a huge expansion in credit issued to consumers and financial institutions. Metallgesellschaft AG engaged in a wide range of activities from engineering to trade and mining and financial services. The firm was exposed to large derivatives related losses at its U.S. oil subsidiary which is known as Metallgesellschaft Refining and Marketing. It had accounted a loss of $1 billion. Metallgesellschaft AG losses were attributed to its wrong hedging program. Risk of Derivative Contracts Risks associated with derivatives are market risk, credit risk, counterparty credit risk, transparency risk, legal risk and basis risk. Counterparty Credit Risk It is the risk that a party to a derivative contract will be ineffective to perform on its obligation. AIG tinted weakness in the supervision of counterparty risk and thus less clearable, OTC derivatives. AIG’s counterparties had decided to only require collateral to cover counterparty risk of American International Group if AIG were downgraded. When American International Group did experience the difficulties simultaneous liquidity squeeze and collateral calls at AIG resulted in its ultimate bail-out to evade systemic outcome. Posting to collateral either through upfront margins or mark-to-market margins is used to minimise counterparty risk to which they are exposed (Fsa, 2009, p.5). Transparency Risk The bankruptcy of Lehman Brothers tinted that positions and disclosure of firms in OTC derivative market were not enough translucent to other regulators or to market participants. This led to disinclination to trade, and thus a need of liquidity (Fsa, 2009, p.5). Legal Risk It is the risk of loss as a contract is found not to be lawfully enforceable. Derivatives are also a legal contract and require a legal infrastructure to grant for the declaration of conflicts and the enforcement of contract provisions. These risks are not distinctive to derivative instruments. It causes special problems for derivative markets (Kuprianov, 1995, p.2). Credit Risk Credit risk also referred as default risk is a type of risk that one of two inequitable under contractual agreement will fail to pay obligations at all or fail to pay obligation within required frameworks. Credit risk played an important role for the downfall of many banks such as RBS and latest financial troubles of Lloyds Banking Group. It can be accessed either quantitatively or qualitatively. Qualitative measures include actively managing collateral requirements as well as establishing long term relationships with borrowers. Other qualitative methods include imposing minimum lower interval for borrowers which are based on internationally accepted credit rating system and restrictive size of business two parties conduct. Qualitative approach have positive influence on credit risk exposure, they are neither sophisticated nor sufficient enough to avoid credit risk. Qualitative measures include discriminant analysis to approximate probability of default. In order to manage credit risk, loan sales and asset securitization are used by UK banks. Total loans to total deposit ratio is also considered as an indicator to eliminate credit risk (Vasilev, 2011, p.25). Market Risk Market risk is defined as the risk of losses arising from unfavourable movements in market rates or market prices. The banks of UK are more and more active in trading derivative instruments and that’s why exposed to unfavourable price movements of derivatives or the price of underlying asset. Value at risk (VaR) and stress testing are the management tools for market risk. In normal market condition, VaR calculates worst case scenario over time interval and therefore VaR models focus on estimating volatility of a portfolio of asset. On the other hand, stress testing draws on basically different assumptions of non-normality. Various worst case scenarios are computed, adjustments made to the portfolio risk profile and balance sheet or income positions are re-evaluated against expected worst cases. In almost all major UK banks, stress testing procedures are applied (Vasilev, 2011, pp.26-27). Basis Risk Basis risk is the difference between the spot price of particular item and its future prices. Stack-and-roll hedging strategy of Metallgesellschaft AG exposed it to basis risk. Benefits of Derivative Contracts Derivatives allow the redistribution or sharing of risk. They are used to hedge against a particular exposure of a business for example default of a creditor, movement in asset price, exchange or interest rate; and also used by market participants to hypothesize on the progress in the value of underlying assets, without ever owing the assets. Derivatives also contribute to the flow of capital and better credit availability. It is used to hedge one’s positions i.e. to reduce the risk inbuilt in foreign currencies, commodities and financial assets. The benefits of derivatives are not restricted to hedging one’s exposure to risk but also to an entire range of risk-return combinations which can be attained using options. For such businesses which do not have control over the external influences on their business, derivatives allow them to manage efficiently exposures to external influences. Derivatives have sound commercial and economic benefits and it has remained necessary towards the development of trade and commerce but it depends on the manner in which they are used i.e. if they are not used in an appropriate manner then it can create a risk to the system. A derivative contract includes one party reducing its risk and other party taking on risk related with an underlying asset. This allows speculating on the values of underlying asset without essentially having any real interest in the asset itself. This use of derivatives with the lack of transparency in the derivatives market can lead to taking too much risk and therefore destabilising the financial system. Through the use of credit default swap, the losses sustained by AIG were because of an immense corporate failure to manage the aggregate risk. Another advantage is the information that can be taken out from various derivatives. Price discovery is one phase of it. Some examples are the ABX indices i.e. the portfolio of collateralized debt obligations of subprime mortgages which are considered one of the first instrument to give information on the dwindling subprime securitization market; option prices on individual equities disclose private information more rapidly into the market; and the exchange traded funds (ETFs) give information on the prices of securities at the forefront of the stale indexes. It also allows the participants to extract forward looking, as contrast to historical, information. Such information is used by central banks in making policy decisions, corporations for administering financial risk and by investors for risk and return decisions on their portfolios. Another benefit is the improvement of liquidity. Adding derivatives to an underlying market has positive effect i.e. derivatives offer a hedge to market makers thus allowing a decrease in transactions costs through a lower bid ask spread (Acharya and et al, 2009, pp.1-2). Conclusion This essay focuses on different types of risks such as market risk, credit risk, counterparty credit risk, transparency risk, legal risk and basis risk to which the banks and companies are exposed to and it also takes into consideration the factors of how the risk can be assessed and measured in order to protect the companies from going bankrupt and enjoy better position. Further, it also takes into consideration the benefits of derivatives contracts. Using them allows sharing of risk; permits businesses to manage exposures to external influences; and it also provides transparency and liquidity. Overall, it depends on the manner in which the derivatives are used. Reference Acharya, V. and et al. (2009). Derivatives- The Ultimate Financial Innovation. Retrieved from http://people.stern.nyu.edu/mbrenner/research/derivatives.pdf. Cox, D.W. (2007). Frontiers of Risk Management. United Kingdom: Euromoney Books. Fsa. (2009). Reforming OTC Derivative Markets. Retrieved from http://www.fsa.gov.uk/pubs/other/reform_otc_derivatives.pdf. Kuprianov, A. (1995). Derivatives Debacles: Case Studies of Large Losses in Derivatives Markets. Economic Quarterly. Vol. 81/4. Reid, M. (2013). An Analysis of the International Derivatives Market. Retrieved from http://www.academia.edu/300222/An_analysis_of_the_international_derivatives_market. Vasilev, D. (2011). Risk Management in UK Banking- The Role of Derivatives Hedging in Particular. 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