Risks Associated with the Use of Derivative Instruments - Essay Example

Financial Service Assignment 2 Table of Contents Table of Contents 2 Introduction 3 Understanding Derivatives 4 Use of Derivatives 6 The Benefits of Derivatives 7 Risks Associated With the Use of Derivative Instruments 10 Conclusion 13 References 14 Bibliography 16 Introduction The financial market is usually referred as a much wider market entailing foreign exchange, commodities, bonds, real estate along with many various financial instruments as well as asset classes. However, a certain section has been stated to form an integral part of the broad financial market and that is the derivatives. This particular market i.e. the derivatives market is believed to have witnessed the most rapid and increased development compared to the other divisions of the market in the recent years. The derivatives division has turned out to be a vital contributor towards the steadiness with regard to the financial structure along with being a significant element in the course of operations associated with the existent economy (Department of Mathematics, 2008). The structure of derivatives market in the present times has been learnt to lure increased concentration next to the present environment related to fraud cases, financial crisis along with the collapse of few of the market participants. It was an evident fact that the recent financial catastrophe principally occurred because of the planned credit-linked securities which were not actually derivatives. This made the regulators and the policy developers think regarding intensification of the guidelines for boosting the lucidity and security for both the wide array of financial instruments as well as derivatives (Department of Mathematics, 2008). Understanding Derivatives Derivatives are referred as financial contracts the worth of which is considered as a resultant of certain definite underlying assets. The underlying assets are believed to entail equity indices as well as equities, loans, exchange rates, commercial along with residential mortgages, bonds, interest rates, commodities and natural calamities like the hurricanes and the earthquakes. The derivative contracts appear or are available in numerous forms however, the most widespread forms entail forwards or futures, swaps and options (Acharya & et. al., 2009). A forward contract is referred to a certain contract in which the involved two parties comply to trade the definite “underlying asset” in the upcoming days at a specific point of time which has been ascertained earlier and at a preset price. Thus, the buyer complies today to purchase a definite form of asset in the upcoming days and the other party i.e. the seller complies to give delivery of that definite asset at the agreed and predetermined time. Futures are regarded as standardised form of forwards that are capable of being dealt in on the exchange (Acharya & et. al., 2009). An option is referred as a contract that provides the purchaser with the right and not any kind of a commitment to purchase or put up for sale the particular underlying asset within a definite span of time in the upcoming days at any ascertained price in opposition to any premium payment which would signify the utmost quantity of loss with regard to the purchaser of a particular option. Thus, unlike futures and forwards, settlement of the options is carried out only at the time they are executed or implemented only under the mentioned condition (European Commission, 2009). In case of a swap contract, two counterparties are supposed to comply with the fact or condition of trading a single flow of cash alongside the other based on a theoretical principal amount (European Commission, 2009). In other words, it could be stated that derivative is referred to a particular contract that takes place among a buyer as well as a seller. The contract is agreed upon in the current day with regard to a business deal which is complied to be executed at a definite point of time in the future. For instance, transferring a definite sum with regard to US Dollars in a mentioned or predetermined exchange rate related to USD-EUR in a particular date in the future. During the tenure of a particular contract, the rate related to the specific derivative is observed to go through a range of vacillations along with the rate related to the supposed “underlying” contract. The tenure related to a particular derivative contract, specifically the definite time that exists between agreeing with the contract or the deal and the final execution or termination related to that particular contract could result to quite an extended period. In few instances, the mentioned time was even observed to last above ten years as well. It is necessary to differentiate the derivatives from the securities which involve the execution of the transactions in just a matter of few days. However, few of the securities are believed to possess characteristics that are similar to a derivatives contract, for instance planned credit-linked securities or warrants and certificates. Although the mentioned form of securities share similar characteristics like that of a derivative but in the real sense they are quite different and thus are not considered as derivatives (European Commission, 2009). Use of Derivatives Largely, the derivatives are considered as instruments that are made use of for the purpose of speculation, hedging and arbitration. With the help of a hedge position, it becomes possible for a particular investor to defend oneself from the extent of risk elements that he/she is uncovered to. The degree or amount of risk that is possible to be hedged with the aid of derivatives could be through the variations related to the market variables and through the element of credit risk (European Commission, 2009). Derivative contracts are also capable to be made use with the intention to hypothesise on the fluctuations related to a particular market variable or even on the creditworthiness. Speculators have been identified to put in the factor of liquidity in the market with the assistance of taking an outlook regarding the course related to such fluctuations. In view of the fact that there entails a requirement of involvement of two parties for entering into a derivative contract, for this reason it becomes necessary for the speculator to look for another party holding a contradictory perception or who would look for ways of spreading a definite form of risk (European Commission, 2009). As a final point, derivatives could be even made use for the purpose of arbitration. A prospect of arbitrage could be explained as the utilisation of the disparities existing in the prices between the markets. Derivatives could even be pooled to imitate the other prevailing financial instruments for the reason of making them competent to join or link the markets by doing away with the price related inadequacies between them (European Commission, 2009). Thus, it could be comprehended from the various applications or usages related to derivatives that it takes on an essential role in the process of price detection. For instance, the derivatives assist in offering the vision related to the market regarding the future progresses associated with the market variables. They are also believed to offer a perception regarding the degree of default risk that is supposed to be associated with a particular sovereign borrower, reference entity or with a certain division related to credit market (European Commission, 2009). The Benefits of Derivatives Derivatives have been learnt to be priced with the help of a hypothetical construction or structure of an imitative portfolio. The non-financial organisations and individuals are learnt to witness much increased degree of costs correlated to trading in comparison to the financial institutions. Therefore, the initial problem related to imitating of a derivative, for instance a certain call option would result in turning out to be prohibitively costly. Secondly, in case of derivatives which entail option characteristics, the strategy related to imitating the portfolio calls for the need of executed trades at the instances of alterations in the prices associated with the underlying. The third problem that would arise in this context would be the aspect of recognising the appropriate imitating strategy (Stulz, 2005). Derivatives are considered to provide suitable solutions for the above mentioned problems. The chief gain or advantage resulting from the derivatives contract is thus regarded to be the facility or rather the permit that is offered to the various organisations and the individuals for the reason of attaining payoffs or inducements. These payoffs or inducements have been stated to be only attainable with the help of derivatives or at much higher prices. Hedging of risks is believed to be only achievable with the help of derivatives. At a certain point of time, the financially viable performers are considered capable of handling the risk in a better way. In such instances, the risks are observed to be accepted by such entities or individuals who are considered to exist in a position that is regarded to be the paramount position for the reason of putting up with such risks. It also makes it possible for the organisations to undertake riskier but increasingly lucrative projects with the help of hedging (Stulz, 2005). Derivatives make it possible for the risks related to the future to be traded which involves two chief advantages. The initial advantage is considered to be the opportunity of getting rid of the ambiguity with the help of switching over the risks connected to the market which is usually referred to hedging. For instance, the corporate as well as financial institutions were learnt to indulge in the application of derivatives for the purpose of safeguarding themselves in opposition to the alterations in exchange rates, prices in relation to the raw materials and interest rates. It was found that the majority of the 500 leading companies’ worldwide handle their respective risks related to prices with the aid of functions associated with derivatives. The other advantage derived from the application of derivatives is considered be an investment. Derivatives have been stated to be a substitute to making direct investments with regard to assets without engaging the requirement of buying or even possessing the particular asset (Culp & Miller, 1995; Department of Mathematics, 2008). The other significant and vital advantage recognised with regard to derivatives is the increased enhancement and competence of the underlying markets which is made possible only with the implementation or practice of derivatives. In the first stage, the derivatives markets are learnt to generate information. For instance, in numerous countries, the possible dependable information regarding the long-standing rates of interest is acquired through the swaps. The market related to swaps is considered to be increasingly liquid along with being active in comparison to the bond market (Stulz, 2005). Derivatives are also measured to be beneficial as it facilitates the investors to enter into dealings based on certain definite information which or else would have proved to be prohibitively expensive in attaining. For instance, it is frequently considered to be quite complicated to put up for sale the stock that is not possessed as the shares then requires to be taken on loan from certain individual who is in current possession of them. This has been found to slow down the pace related to the integration of the unfavourable information within the stock prices as a result of which the markets tend to lose its effectiveness. With the help of ‘put options’, a particular derivative that is measured or considered to imitate the dynamics related to sort selling, the investors are facilitated to take complete benefit of the unfavourable information regarding the stock prices in a more simple and uncomplicated way (Stulz, 2005). Derivatives have been already mentioned to be made use to hedge risks by various organisations. This implies that such organisations are actually making endeavours to put to use such kind of contracts in the form of insurance to shield themselves from adverse consequences in the future. In situations when the derivative instruments are put to use for the purpose of hedging risks then it implies that the derivative instruments that are involved shifts the degree of risk from those individuals or hedgers who appear to be reluctant to put up with the risks. The risks are shifted to such individuals or entities that are measured to be competent enough and appear to be more prepared to take the responsibility of the risks. Therefore, it could be mentioned in this context that derivatives aid in distributing the risk proficiently among various groups as well as individuals with regard to the economy (Sill, 1997). The derivatives contracts have also been recognised to prove to be helpful when it comes to risk distribution. This becomes possible owing to the fact of the prospects related to economical leverage that are offered by the derivatives contracts to the respective investors. Leverage has already been identified to be attained with the help of forward contracts. In such instances of forward contracts, the leverage results from the actuality that no cash is required at the point or time of entering into such agreements or contracts by the involved parties (Sill, 1997). It becomes important to be mentioned in this regard that usually derivatives are considered to be the instruments that help in bringing down the degree of risks for the made investments of the investors. Widening the menu related to the accessible options aids the investors to modify the degree of risk related to their own respective arbitraging, investment or hedging situation. Derivative contracts have been measured to facilitate the investors to influence comparatively minimum sum of funds based on a broad variety of assets as a result of which their respective portfolios get diversified (Stulz, 2005). Risks Associated With the Use of Derivative Instruments The derivative instruments have been found to be applied and made use by numerous organisations as well as individuals as a strategy for the purpose of dealing with the different kind of risks witnessed by them. The complex methods related to the risk-management helps in reviewing the general riskiness related to the investment portfolios entailing options along with other forms of derivatives. However, evaluation of the degree of risk with regard to such portfolios usually calls for the requirement for practitioners to make use of appropriate representations regarding option pricing which are just considered as rough calculations. It has been observed that in certain instances these representations fail to display the desired level of performance expected by the practitioners. This could make the organisations get caught in situations where it could discover itself to be open to the elements of risk to a large or small extent than it had aspired for. To add further, financial innovation is believed to have directed towards fresh and increasingly exotic securities which are considered to be trickier when it comes to pricing. Therefore, the factual errors associated with the different pricing models might direct the traders as well as the investors as well (Stulz, 2005). The other risk associated with the financial derivatives is stated to be the credit risk which is referred to the failure to make payments by one of the involved parties with regard to the contract. Credit risk is not taken much into consideration in case of derivatives, which is dealt in at the organised exchanges as these exchanges entail such structures which ensure the execution of the contracts in most of the instances. On the other hand, credit risk is measured to be quite a grave reason of concern in the case of Over The Counter (OTC) market. This market entails problem related to the credit risk as in these markets both the parties indulge in bargaining over a certain derivative contract which particularly suits their respective requirements. For instance, a particular bank might indulge in engaging itself in counterbalancing the swap provisions with two organisations. If neither of the organisations fails to make payments then the position of the bank could be regarded as completely hedged. However, in an instance when one of the organisations fails to meet up to the payment requirements then in such a situation the particular bank would still involve the responsibility or obligation of executing the contract with regard to the other organisation which makes it suffer from credit risk. Therefore, banks could indulge in attempts related to risk alleviation by entailing the need of security or rather guarantee from the organisations getting involved with the swap contracts or even by attaining securities with regard to third-party (Whaley, 2006). The other risk that is measured to be involved with the application of derivative instruments has been referred to be the liquidity risk. This usually implies to the effortlessness or rather easiness that is associated with the trading of a particular contract. This particular form of risk does not get limited only to the derivative contracts but is also believed to participate in a vital role with regard to any kind of financial market through the phases of increased instability or noteworthy alterations in relation to the economic essentials. The system associated with the OTC as well as the standardised markets has been regarded to be sufficient to handle the risk related to liquidity in the earlier period. When securities are found to turn illiquid then it becomes increasingly tough to ascertain their respective values. As a result, when organisations attempt to put up for sale such liquid securities then the organisations might encounter substantial differences in the prevailing market values related to their securities as well as portfolios compared to their recorded values (Hentschel & Smith, 1995). Conclusion A remarkable development in the derivatives market has been witnessed in the past 10 years. While a great deal of discussion and assessment was done regarding the losses related to derivatives, yet the economic advantages offered by such derivative securities hold more importance. From the above discussion, it has been evident that the derivative contracts facilitate the organisations as well as the individuals to hedge their respective degree of associated risk or enable them to put up with the degree of risk with the involvement of a minimum cost. However, the derivatives contracts have also been measured to be competent enough to initiate risk possibilities at the organisational level, particularly in cases where an organisation is considered to lack experience in their applications or comprehension of the situations. Organisations need to ensure that the derivatives are implemented or are made use of appropriately. This implies that the measurement of the risks associated with the derivatives positions require to be done appropriately and also needs to be properly comprehended. The organisations in order to avoid risks arising out of derivatives contract requires to entail well-structured and definite guiding principles regarding the application and practice of derivatives. The derivatives contracts aid the economy to attain an effectual way of distributing the risk. References Acharya, V. & et. al., 2009. Derivatives – The Ultimate Financial Innovation. Journal of Applied Corporate Finance, pp. 1-13. Culp, C. L. & Miller, M. H., 1995. Hedging in the Theory of Corporate Finance: A Reply to Our Critics. Journal of Applied Corporate Finance, pp. 121-127. Department of Mathematics, 2008. The Global Derivatives Market: An Introduction. Deutsche Borse Group, pp. 1-42. European Commission, 2009. Ensuring Efficient, Safe and Sound Derivatives Markets. Commission of the European Communities, pp.1-47. Hentschel, L. & Smith, C. W., 1995. Risks in Derivatives Markets. The Wharton Financial Institutions Center, pp. 1-26. Sill, K., 1997. The Economic Benefits and Risks of Derivative Securities. Federal Reserve Bank of Philadelphia, pp. 1-26. Stulz, R. M., 2005. Financial Derivatives. The Milken Institute Review, pp. 20-31. Whaley, R. E., 2006. Derivatives: Markets, Valuation and Risk Management. John Wiley and Sons. Bibliography Chance, D. M. & Brooks, R., 2009. Introduction to Derivatives and Risk Management. Cengage Learning. Choi, J. J. & Elyasiani, E., 1996. Derivative Exposure and the Interest Rate and Exchange Rate Risks of U.S. Banks. Wharton University of Pennsylvania, pp. 1-23. Greuning, H. V. & Bratanovic, S. B., 2009. Analyzing Banking Risk: A Framework for Assessing Corporate Governance and Risk Management. World Bank Publications. Kramer, A. S. & et. al., 2010. Guest Analysis: Negotiating Over-The-Counter Derivative Contracts. Thomson Reuters Accelus, pp. 1-12. Read More