Finance and Accounting - Essay Example

? Table of Contents (Part 2 (Part-2) 4 (Part-3) 6 References 8 (Part It is evident from the definition of derivatives 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 (European Union Committee, 2010). 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 positions and in some cases they can choose high level of leverage as a strategy (Stromqvist, 2009). Economic justifications provided for hedge funds in the financial markets are that hedge funds have expanded the horizon of investment strategies, with the consent of higher profits it has helped in increasing investors’ participation in derivatives and thus has enflamed the size of capital available in the market. It is stated that hedge funds are uncorrelated to the returns of equity and fixed income market which help investor in managing their risks (Greenspan, 2005). Hedge fund provide diversified sources, strategies and securities to investors which help in reducing risks on investment. During normal market conditions and especially in times of stress, private investment companies deliver appreciated liquidity by buying irrationally low-cost assets and by sell irrationally costly assets which reallocates the capital and improve liquidity. Hedge funds have the ability to employ securities in several markets at the same which in turn increases return opportunities and besides this innovation helps in hedging risks (Fung & Hasieh, May 1999). Hedge fund managers enjoy the flexibility to invest where ever they conceive higher returns which helps in exploring more opportunities. Hedge managers use combination of short and long positions, employ derivatives, leverage their portfolio, ponder their investments, make investments in illiquid assets and take risks. This flexibility allows more innovations and creates opportunities (Francois-Serge, 2002). Hedge managers focus to improve the shareholder value of the company by expressing their ownership and involvement in management and strategy decisions such as encouraging mergers or acquisitions, reduction in expenses, disbursement of cash reserve whether through channel of buybacks or dividends or by cutting compensation of executives etc. (Part-3) Euro area crisis is the crisis combining many factors such as debt crisis due to extensive borrowings, banking crisis and growth crisis. As a hedge gund manager with porfolio of share from French, German and Spanish listed firms, I will employ in reducing operational risks and will struggle to improve the shareholder value of the company. In times of crisis, it is advised to use event driven strategies which are helpful in capitalising opportunities according to the pertaining conditions and risks. I will invest in the distressed securities of the companies facing political and economic crisis in eurozone. I will opt for short positions of currencies, bonds and stocks as my priority because euro area crisis is not an issue that will resolve in days or months rather it will take years to resolve. In the meanwhile this invesment fund in the securities of the disstressed companies will help mitigating volatile risk of euro crisis ups and downs. There is an uncertainity of Greek exiting from the Eurozone along with the strengthening of regulatory framework will create more opportunities for investment in buying and sellings of companies. In such scenarios assets prices, interest rates and default of creditor can only be hedged through short/ medium term positions. I am certain that this investment fund in distressed companies will efficiently respond to the Eurozone crisis. The volatility of prices presents greater opportunities for hedge fund managers but here in euro crisis, all such measures have failed which also requires an operational readiness for currency redenomination as the risk of Greek exiting the Eurozone has destabilise the euro area more than the crisis itself. This risk has brought my decision to take business exposures in European counterparties such as in America or in Asia. If analysing the impact of Greek exiting Eurozone and currency redenomination, I will prefer change in investment strategy as I opted for the event driven strategy, due to possible change in the shareholder value of the company; I will employ changes to cash and liquidity holdings. In case if above two changes do not incur company standing then my last resort will be to explore business market in European counterparties. References Andrew W. Lo, 2008., “Hedge Funds, Systemic Risk, and the Financial Crisis of 2007-2008: Written Testimony for the House Oversight Committee Hearing on Hedge Funds”. European Union Committee, 2010. The future regulation of derivatives markets: is the EU on the right track?, s.l.: House of Lords London : The Stationery Office Limited. Financial Services Authority and HM Treasury, 2009. Reforming OTC Derivatives Markets: A UK perspective, s.l.: s.n. Francois S. L., 2002. “Hedge Funds: Myths and Limits”, s.l.: Hoboken, N.J.: John Wiley & Sons, Ltd. Fung, W. & Hasieh, D. A., May 1999. “The Truth about Hedge Funds”, s.l.: Cleveland Federal Reserve. Greenspan, Alan, 2005., “Risk Transfer and Financial Stability”, s.l.: s.n. International Derivatives and Swaps Association, 2009. Derivatives Usage Survey, s.l.: s.n. Managed Funds Association, 2009. Sound Practices for Hedge Fund Managers. SHORTMAN, J., 2010. “How competitive are hedge funds, and are they a help or a hindrance in driving the economy out of recession?”, Norwich Economics Papers. Stromqvist, M., 2009. “Hedge Funds and Financial Crisis”, s.l.: Economic Review. Read More