Heavy Losses from Using Derivatives - Essay Example

? Financial services Contents Derivative contracts 3 Recent examples of banks and companies making heavy losses from using derivatives 3 Evaluation of the risks and benefits of derivatives contracts 5 References 8 Derivative contracts Derivative contracts are financial instruments whose value is derived from the value of its underlying assets, security, market index, etc. The underlying factors of the market that determines the value of derivative contracts may be currency conversion rates, interest rates, equity prices, commodity prices, etc. The derivative contracts may take the form of options, swaps, futures, forwards, etc. Transactions on derivative contracts occur between two parties in which a financial agreement is done whose payments depend on the value of the underlying assets and securities. Derivative contracts are broadly categorized into lock and option products. Lock category derivative contracts bind the two parties into an obligation of executing the contract according to the terms and conditions over the period for which the contract is agreed upon. Option product derivatives are contracts that provide the right to the buyer but not the obligation to execute the contract over the period of the contract (Whaley, 2007, p.121). The derivative contract includes an agreed upon price between the two parties to buy or sell the product within a specified period of time. The derivative contracts may be traded in the exchange in which case these are called exchange-traded-derivatives or may be privately traded in which case these are called Over-the-counter derivatives. Over the counter derivatives are not traded in specialized exchanges. Recent examples of banks and companies making heavy losses from using derivatives The financial meltdown of 2007 in US was largely due to the fall in the mortgage prices which served as underlying assets for loan products. Irresponsible lending, relaxed policies of the banks, corporate houses and happy-go-lucky attitude of the regulators in assessments of the derivative products led to the fall of big banks like Lehmann Brothers. After a meagre financial recovery from the support of the government, derivative market is again one of the biggest markets in today’s global financial scenario (Schwartz and Smith, 1997, p.499). Banks today are carrying out transactions on derivative markets on a much larger scale than ever before. The banks are more opaque and are indifferent to the risky derivative products. Banks, however, are unwilling to disclose the face of the derivative contracts to their investors. It is understood that a change in the underlying market factors would lead to massive losses of the world economy as a result of devaluation of the underlying assets. The size of the derivative markets has grown from $500 trillion in 2007 to $707 trillion in 2011. Lack of transparency in trading of derivative contracts reflect the risk involved as a result of probable fluctuation of underlying market factors. This can be observed in the light of recent examples. J P Morgan has registered a loss of $6 billion due to trading in risky derivatives. The increasing size of derivative markets and declining due diligence in investments in order to achieve higher profits imposes higher risk. Several high ranked officials from big companies like Meryl Lynch, Morgan Stanley, and Citigroup commented that the banking industry is vulnerable in the wake of huge losses in derivative markets. After the earthquake in Japan, J P Morgan decided to reverse their position in derivatives due to the huge losses to be incurred. In 2011, Deutsche Bank decided to reduce the foreign currency exposure of Post bank by €8.1 billion looking at the heavy losses in their investment in derivatives. Deutsche bank themselves lost $1.74 billion in US derivative markets. A huge foreign exchange option for Hewlett Packard was executed early in order to reduce the losses predicted out of market uncertainty. Due to lack of transparency on the investments in derivative markets, some of the recent huge losses have been kept secret from the investors (Pinto, CFA, Henry, CFA, Robinson, CFA, Stowe and CFA, 2010, p.18). Morgan Stanley has incurred a loss of $8.67 billion in the credit default swaps in US derivative market. Due to fall in performance of oil future, Metallgesellschaft incurred a loss of $2.28 billion in Germany. Merrill Lynch lost $0.51 billion from their trading in mortgages. Many other companies who have incurred huge losses from their investment in derivatives include Sumitomo Corporation of Japan, UBS of UK, CITIC Pacific of China, Bank of Montreal, Manhattan Investment fund and many other companies all over the world. Thus in the light of recent examples, it can be seen that the increasing market size of derivative instruments and the lack of due diligence and transparency towards risk derivative transactions have resulted in huge losses of big companies and banks all over the world (Moyer, Moyer, McGuigan, Rao and Kretlow, 2012, p26). Cautious approach by the market players in undertaking derivative contracts is necessary to avoid massive financial losses which may have a rippling effect in the international stage. Evaluation of the risks and benefits of derivatives contracts The derivative contracts contain certain benefits as well as risks associated with their execution. The riskiness of the derivative contracts can be categorised into four sections. These are market risk, operational risk, counterparty credit risk and legal risk. The market risk of derivative contracts explains the risk due to the fluctuation in market conditions. Fluctuation in market conditions would lead to difference in valuation of underlying assets, securities, interest rates, currency exchange rates, etc. The valuation of derivative contracts is thus subject to uncertainty due to market risk (Higham, 2004, p24). In the light of recent losses in the derivative markets, the devaluation of underlying mortgage and securities as a result of fall in prices of properties in US are examples of market risk. Operational risk occurs due to absence of proper systems of management, errors and failure in management of derivative contracts. Operational risk in terms of lack of due diligence before investment and lack of transparent disclosures have led to huge losses in derivative markets. Risk of derivative contracts also take into account the counterparty credit risk. The inability of the counterparty to execute the derivative contracts lead to failure of derivative contracts and thus resulting in huge losses. Derivative contracts need to be enforced legally in case of conflicts (Brigham and Ehrhardt, 2011, p14). Thus a legal infrastructure for resolution and timely transaction of derivative contracts is essential. There may be derivative contracts which are not legally enforceable leading to risk. Apart from the risk factors, derivative contracts also carry certain benefits with them. Derivative contracts are used to hedge risk factors. Due to fluctuation of underlying market factors, the valuation of underlying assets, securities and interest rate, currency conversion rates undergo changes leading to future uncertainties. With the help of derivatives, the value of the underlying asset is fixed for specified timeframe thereby reducing the risk of undervaluation of the assets. Thus derivative contracts are beneficial to safeguard against uncertainties of market factors. The derivative contracts have economic as well as commercial advantages. A company may have business in diversified products and across several countries. Thus the market risk and business risk in that case would be correlated to the factors of country risk. The derivative contracts are used by the companies to diversify the risk of different businesses they are engaged into. The financial losses in some derivative contracts may be offset by the financial gains in other derivative contracts of the company. Derivative contracts may also be used by companies to meet future expenses from its earnings or pay off any liability from the earnings of derivative contracts. After taking into account the benefits and risk factors, the companies use derivative contracts in order to fulfil their objectives of strategic growth (Hitchner, 2011, p.12). Derivative contracts have been widely adopted by the companies in recent business scenario but due diligence in assessing the underlying market factors become essential to reduce the riskiness of derivative contracts. References Brigham, E. F. and Ehrhardt, M. C. 2011. Financial Management: Theory and Practice. Cengage Learning; USA. Higham, D. 2004. An Introduction to Financial Option Valuation: Mathematics, Stochastics and Computation, Volume 13. Cambridge University Press; UK. Hitchner, J. R. 2011. Financial Valuation: Applications and Models. John Wiley & Sons; USA. Moyer, Moyer, R. C., McGuigan, J. R., Rao, R. P. and Kretlow, W. J. 2012. Contemporary Financial Management. Cengage Learning; USA. Pinto, J. E., CFA, Henry, E., CFA, Robinson, T. R., CFA, Stowe, J. D. and CFA. 2010. Equity Asset Valuation. John Wiley & Sons; USA. Schwartz, R. J. and Smith, C. W. 1997. Derivatives Handbook: Risk Management and Control. John Wiley & Sons; USA. Whaley, R. E. 2007. Derivatives: Markets, Valuation, and Risk Management. John Wiley & Sons; USA. Read More