Derivatives

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Topic D: Derivatives (e.g.. options, futures) are often criticized for being too risky and causing massive losses to investors (e.g. Barrings Bank, LTCM). Explain the role of derivatives in financial markets and their desirable and undesirable uses.

The use of derivatives in the financial market has dramatically increased in recent years. This relevantly recent change in the status of derivatives has led to calls for increased regulation. Fears that using derivatives to hedge against risk carries in itself a new risk which was brought sharply into focus by the collapse of large major financial institutions such as LTCM and Barrings in 1995.

To explain the role of derivatives in the financial markets, we need to understand what derivatives are, how they can be used to minimize risk and why there is such an increasing pressure to increase regulation on the use of derivatives as a financial tool.

Derivatives are financial contracts whose value derives from underlying securities prices. For example: Interest rate, foreign exchange rates, market indexes or commodity prices. Exchange-traded derivatives are standardized products traded on the floor of an organized exchange and usually require a good faith deposit, or margin w

The unpredictable and at times turbulent, nature of OTD derivatives markets would merit little concern if OTC derivatives were an insignificant part of the world of global finance. They are increasingly becoming an important instrument in the global finance world.

"For an example of how derivatives work, suppose we consider a Small Regional Bank (SRB) with total assets of $5million. The SRB has a loan portfolio composed primarily of fixed-rate mortgages, a portfolio of government securities and interest-bearing deposits that are often re-priced. They can use derivatives to hedge their risks: Rising interest rates will negatively affect prices in the SRB's $1 million securities portfolio. But by selling short a $1million treasury-bind futures contract, the SRB can effectively hedge against that interest-rate risk and smooth its earning stream in a volatile market. If interest rates went higher, a drop in value of its securities portfolio would hurt SRB, but that loss would be offset by a gain from its derivative contract. Similarly, if interest rates fell, the bank would gain from the increase in value of its securities portfolio but would record a loss from its derivative contract. By entering into derivatives contract, the SRB can lock in a guaranteed rate of return on its securities portfolio and not be as concerned about intere

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Approximate Word count = 903
Approximate Pages = 4 (250 words per page double spaced)

Category: Miscellaneous

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