The Implications of Welbys View with Specific Reference to Commodities Futures Markets - Essay Example

Welby’s Views on Commodities Futures Markets Businesses are mainly created with the main aim of making profit. However, they operate in an environment that is full of risks (Dorfman 1997). One of the main ways through which businesses try to overcome these risks is by using derivatives. Some of the most common derivatives in this respect include credit default swaps, mortgage-backed securities, options, forwards, and futures. In as much as these derivatives are partly dedicated to reducing certain risks, they often carry with them huge risks. In relation to this fact, Welby (1997) notes that these financial instruments in effect increase both the level and complexity of risk in the financial system even though they outwardly appear to mitigate these risks. Many industries rely on commodities futures as a way of mitigating risks associated with price and foreign exchange fluctuations. Commodities futures basically involve the establishment of a standardized contract between two parties, the buyer and the seller. The contract specifies the standardized quantity and quality of asset to be exchanged between the buyer and the seller on a future date based on a price that is agreed on today. As an example, an airline that needs to operate its fleet of aircraft in an environment in which the price of oil constantly fluctuates may opt to enter into a futures contract with a company that deals in oil. Based on the contract, the airline agrees to buy a given quantity of the product at a given price sometime in the future. Through such a contract, the airline hopes to hedge against the ever rising price of oil and so reduce the risk of having to buy the commodity at a much higher price. The airline in the above case is bound to buy the quantity of fuel at the price agreed on even though the price of oil may reduce in the market against expectation. In such an event, the airline ends up paying a higher price for the commodity than what it would otherwise have paid without the contract. What this means is that the futures contract may in itself increase the risk that it was originally intended to solve or mitigate. Financial instruments such as commodity futures are helpful in mitigating price risks, quantity risks, and cost risks as noted by Dorfman (1997). While they are also dedicated toward ensuring that the contacting parties honour their part of the deal, it is beyond doubt that there are several risks that accompany them consequently. Some of the risks associated with financial instruments such as financial instruments include market, interest rates, currency, assimilation, operational, liquidity, credit, legal, political and settlement as noted by Delta Stock (2015) and Clark (1997). Worth noting is that it is not only the contracting parties or that face these risks. Some of the risks are extended to external parties such as governments, exporters, and shareholders. Governments for example, face the risk of losing a lot in taxes when organizations under-rate the value of their derivatives. On their part, shareholders may not be able to tell the kind of risks the companies they are investing in face. Based on the neo-classical Economic perspective, derivatives are like insurance policies that serve to mitigate risks through hedging. In this respect, businesses use the derivatives to neutralize risks that they are exposed to by transferring them to counterbalancing derivatives (Banks 1993). What this means is that businesses can repackage derivatives to unbind themselves from associated risks thereby creating different risk profiles. Furthermore, these derivatives can expose entities to risks without necessarily having to own underlying assets from which these risks are derived (Banks 1997). Indeed analysts have noted that derivatives such as commodity futures can create significant feedback effects to the extent that they do not merely draw their value from assets that underlie them but from trends of their value on the market as well. Not all entities use derivatives for hedging purposes. Some of them use them for speculative purposes and thereby take on risks in the hope of earning huge profits (Banks 1997). Given that the price of a derivative is a fraction of the underlying asset’s price, it accords exposure to the underlying asset and therefore gives investors the opportunity to leverage on their capital. The loss or profit that possibly arises from the acquisition of a derivative owing to the evolution of the value of the asset upon which it is based may equal the loss or profit of speculating in the asset itself without the having to buy it. In this respect, derivatives give investors the opportunity to raise the potential for a higher rate of return on the capital they have while taking on a level of risk that is significantly higher as noted by Oliver (n.d.). Analysts note that when there is a sudden shift in average opinion regarding a commodity product, or organization, the economy can suffer catastrophic disruptions (Oliver n.d.). This being the case, it is reasonable to argue that the growth of highly leveraged derivative products has amplified the market’s speculative dimension (Shiller 2003). To this extent, the use of derivatives for the purpose of speculation has increased systemic risk to the extent that players in the market do not fully appreciate the risks of their actions, thus creating negative externalities have to be absorbed eventually by the rest of society. As an example, the recent global financial crisis came into being as a result of the misuse of derivatives. The mortgage-backed securities were issued to subprime individuals who ended up defaulting. Furthermore, banks, insurance organizations, and rating bureaus worked together toward giving a highly skewed notion of how the market was real estate market was performing. Just like the mortgage-backed securities heightened the risks faced by different parties, commodity futures have the potential of disrupting markets if they are not properly regulated. The calculation of risks associated with commodity futures and other derivatives is quite complex especially given that several factors must be taken into account to come up with accurate figures. Some of the factors in this respect include historical data, levels of probability, changes in prices, changes in the rate of underlying position, interest rate changes, time decay and volatility according to the Office of the Superintendent of Financial Institutions (2015). In the world of financial derivatives the speculator is confronted by the incalculable and uncertain according to Oliver (n.d.). It remains a fact that these derivatives are objects of speculation given that the market value of their financial claims are merely on paper and can be inflated or driven up artificially. Consequently, the demand and supply factors can easily be manipulated for profit. Yet again, derivatives may be seen as a means of imposing risks on others as opposed to managing risk if the view that finance is a dominant part of capital is held. What this implies is that derivatives can serve to deepen crises or may create new ones. Conclusion Welby’s view that new derivatives increase the level and complexity of risk in the financial system has a lot of merit. It is evident that financial instruments such as commodity futures are used by organizations to hedge against price fluctuations. Since the price of the commodity is preset, those who participate in the transaction know in advance the amount they will need to sell or buy. In this way, the retail buyer has spends less on commodities since the manufacturer is less likely to increase prices to accommodate profit losses in the cash market. Yet again, they are used for speculative purposes by parties interested in making huge profits without necessarily owning assets upon which these derivatives are based. Even as they are used as financial instruments, the level of risk that come with the use of commodity futures and other derivatives grow. While they may effectively serve to stabilize the prices of goods and in dealing with the risk of defaults, the buyers and sellers of these derivatives end up facing quite a number of risks. Some of these include market, interest rates, currency, assimilation, operational, liquidity, credit, legal, political and settlement risks. Furthermore, the instruments may end up creating externalities that the society is forced to bear. Yet another risk associated with commodity futures is that they may worsen crises and create new ones. In this respect, critiques of derivatives argue to a great extent, they are detached from the real productive economy. The net effect in respect of this is that use of commodity futures and other derivatives increase the risks faced not only by the trading parties but also governments and members of the society. Apart from increasing the level of risk, commodity futures increase the complexity of risks. This is evident in the numerous factors that have to be taken into account in determining risks related to commodity futures. Some of these factors include: historical data, levels of probability, changes in prices, changes in the rate of underlying position, interest rate changes, time decay and volatility. References Banks E. 1993, Complex Derivatives: Understanding and Managing the Risks of Exotic Options, Complex Swaps, Warrants, and Other Synthetic Derivatives. McGraw-Hill, London. Banks E. 1997, Credit Risk of Complex Derivatives (Finance and Capital Markets Series), Palgrave Macmillan Ltd, London. Clark E. 1997, “Valuing political risk”, Journal of International Money, and Finance, vol. 16, no. 3, 484-485. Delta Stock 2015, General Description of the Financial Instruments and the Risks Associated with Them, viewed March 2, 2015 https://www.deltastock.com/english/mifid/financial_instruments.htm Dorfman, M. 1997, Introduction to Risk Management and Insurance (6th ed.). Prentice Hall. London. Office of the Superintendent of Financial Institutions 2015, Derivatives Sound Practices, viewed March 2, 2015 http://www.osfi-bsif.gc.ca/eng/fi-if/rg-ro/gdn-ort/gl-ld/pages/b7.aspx Oliver B. (n.d.) Over The Counter (OTC) Financial Derivatives and the regulation of risk within complex markets. University of Exeter. Shiller, R.J., 2003, “From Efficient Markets Theory to Behavioral Finance”, The Journal of Economic Perspectives, 17 (1), pp.83-104 Welby J.1997, The Ethics of Derivatives and Risk Management, Ethical Perspectives, vol. 4, no. 2, pp. 84-93. Read More