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Finance and Accounting - Essay Example

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It is evident from the definition that they redistribute and reallocate the risk generated in the economy.In such circumstances derivatives are the perfect instrument to transfer risk, which can utilized either for hedging risk or obtaining risk…
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Finance and Accounting
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Download file to see previous pages A survey conducted by International Swaps and Derivatives Association (ISDA) revealed that out of 500 corporations, around 94% of the companies used derivative tool and they efficiently succeeded in hedging risks (International Derivatives and Swaps Association, 2009). It is seemingly clear that derivatives have economic and financial benefits for business which means they have resulted in making global financial markets safer. However, with the emergence of derivatives for financial speculations has brought this instrument under heavy criticism for making financial sector more risky and has been criticised for financial crisis. So, derivative have some benefits and risks too. The first most advantage of derivatives is the restructuring of risks by which movement in assets prices, interest rates and default of creditor can be hedged. They help in speculating the movement in the value of assets when they do not even own the assets. Secondly derivatives allows businesses to accomplish in controlling the external factors efficiently. Derivative instrument has been criticised for being used only for speculations. Derivatives contracts reduce the risk of one party while increases risk of the underlying assets for other party; this allows both parties to speculate the value of the principal assets irrespective of the fact parties are interested in the contract or not. Derivative instruments have efficient and effective economic and financial advantages which are required for the development of businesses and trade to hedge risks but it depends on the usage of this instrument which can pretence risks. Derivatives were criticised for lack of transparency in the OTC derivatives market under which standings of firms, their movement in asset prices and interest rates are not adequately transparent to the regulatory authorities and to other business companies (Financial Services Authority and HM Treasury, 2009). Sometimes business firms in the market are unaware of the market standings of other companies which adds to more risks as monitoring of risks is weak and unwillingness for trade and hence the market liquidity may reduce. Derivatives contracts are affected by both operational risks and systematic risks. It is argued that operational risks can be improved by physical clearance of underlying assets and by addressing valuation differences. (Managed Funds Association, 2009) On the other hand systematic risks are caused by default of major stakeholders of derivatives market. It is usually referred to as “domino effect” (Investment Management Association, 2011). Derivatives of credit default swaps have the ultimate vulnerability to risks because they are more problematic in assess the value of underlying assets. Former Chairman of Federal Reserve, USA stated in a conference that “Although the benefits and costs of derivatives remain the subject of spirited debate, the performance of the economy and the financial system in recent years suggests that those benefits have materially exceeded the costs” (Greenspan, 2003). (Part-2) Hedge funds are targeted to generate higher absolute returns for different type of investments. Hedge funds use highly advanced strategies for investment which comprise leveraged, short, long, and derivative positions designed for sophisticated investors. As hedge funds targets for higher returns that makes them more volatile and riskier besides profit compensate the risks at the end (SHORTMAN, 2010). Hedge funds are more liberal with respect to regulations and regulatory framework which makes them more flexible to use dynamic, vigorous and vibrant investment strategies with the combination of long, short and derivatives ...Download file to see next pagesRead More
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