Financial Derivatives This Study Emphasized the Importance

Financial Derivatives This study emphasized the importance roles of financial derivatives, which has been known for the last decade and its effects on the Global financial crisis. It further analyzes the impact of financial derivatives and how it can be controlled to prevent corporations from incurring a lot of risks. It also explains the existence of financial derivatives since 1970, to the recent Global Financial Crisis which occurred in the 2006. Risk is a feature associated with all productivity.

As a result, financial markets adjust themselves to the fluctuation of exchange and interest rates. Hedging risk, these corporations highlight the importance of risk management tools known as Derivatives. Derivatives are defined as financial tools providing investors with effective solutions when avoiding risk caused from market volatility (Dodd, 2006). Financial derivatives are considered to be an effective risk management tool associated with Financial Engineering creating solutions to financial problems (Marks, 2010).

In this paper, derivatives are explained as financial tools used to hedge against risk and speculate future market conditions for investors, while proving to be "financial weapons of mass destruction." Congress has been forced to regulate derivatives to the demand of derivative transparency underlying potential risk to investors in order to prevent a relapse like the one which occurred in the year 2008 (G. Corsetti, 2004). Financial firms use derivatives to speculate trading as well as, hedge against unwanted risk in the market (D. Krawiec, 1997).

The question asked every time is how this is done? Investment firms normally use speculative trading to foresee market conditions allowing two firms to exchange interest rates, which entails "swapping only the interest related cash flows between two parties in the same currency." An interest rate swap is a financial instrument serving the purpose of "altering the interest rate exposure of a firm's debt.

It's the ultimate interest rate exposure to their debt to which firms are managing." These bilateral contracts typically between corporate bond issuers, borrowers, and dealer (investment banks) exchange two types of interest rates. The first is a fixed rate liability, which consists of coupon bonds usually 5%. The second is a floating/variable rate where market conditions are reflected upon interest rates. i.e. An Investment Bank and Apple enter agreement where Apple has "synthetically" created a floating rate liability.

The swaps are priced in order to equate the fixed rate payments to the expected floating rate payments > PV Floating cash flows = PV Fixed cash flows History of Financial Derivatives Financial derivatives have been there for many years; therefore, it's not a new concept. The first known one can be found in Aristotle's writings, which tell a vivid tale of Thales, a poor philosopher from Miletus who developed a "financial device, involved in a principal of universal application (Dennett, Searle, 2010).

Thales stated that lack of wealth was good evidence that philosophy was a useless occupation and has no practical value. He made plans to prove to others his wisdom and intellect and show that he knew what he was doing. Thales could forecast and predict that the outcome of the olive harvest would be good in the next autumn.

He was so confident in his prediction to an extended of signing agreement with area olive owners to deposit his money with them, to guarantee him their olive when the harvest is ready. He could negotiate low prices for the olive, because the harvest was in the future and nobody knew whether the harvest would be plentiful or pathetic, and because the olive owners were willing to hedge against the possibility of a poor yield.

When harvesting period came he made a good quantity of money due to plentiful of harvest. He later made an option and sold the olive to the olive press owner at a higher profit. Most financial derivatives which are being traded today are the "plain vanilla" variety which is the simplest form of a financial instrument. But the variants on the basic structures have given way to more sophisticated and complex financial derivatives that are much more difficult to measure, manage, and understand.

For those instruments, the measurement and control of risks can be far more complicated, creating the increased possibility of unforeseen losses (T.F. Siems, 1997). Moreover, Wall Street's "rocket scientists" are consistently making new, complex and sophisticated financial derivative goods. However, the goods they made are on a foundation of the four basic types of derivatives (Matthew, Leising, 2000). Most of the newest innovations are designed to hedge complex risks in an effort to reduce future uncertainties and manage risks more effectively.

But the newest innovations require a firm understanding of the exchange of risks and rewards. To that end, derivatives users should establish a guiding set of principles to provide a framework for effectively managing and controlling financial derivative activities. Those principles should focus on the role of senior management, valuation and market risk management, credit risk measurement and management, enforceability, operating systems and controls, and accounting and disclosure of risk-management positions (Thomas F.Siems, 1997). Financial Derivatives are speculative and leveraged instruments Look it in a wider detail.

Are derivatives only used to speculate the direction of interest rates or currency exchange rate? The answer is no. However, the emergence use of explosive financial derivatives products seen in recent years was due to three primary forces: more volatile markets, deregulation and new technologies (M Watson, 2007). Things changed abruptly in the early 1970s when the breakdown of fixed rate international currency occurred. From that time the currencies have floated freely (D. Henley, 1997).

However, banks and other financial institutions reacted to the new environment by developing financial management risk product which is designed to a better control. The first were simple foreign-exchange forwards that compelled one to buy, and the other to sell, a fixed amount of currency at an agreed date in the future. By entering into a foreign-exchange forward contract, customers could offset the risk that large movements in foreign-exchange rates would destroy the economic viability of their overseas projects.

Thus, derivatives were originally intended to be used to effectively hedge certain risks; and, in fact, that was the key that unlocked their explosive development (Meera, 2000). However, to secure the future of banks and other corporations, simple forward agreements and financial futures contract were developed. These futures and forwards are similar, but the only different is that futures are standardized by exchange clearinghouses, thus allow it to facilitate trading in a more competitive and liquid market. Besides, the futures contract are daily marked in the market, however, decrease counterparty risk.

The first swap contract was developed in the year 1980. A swap is another forward-based derivative that compelled two counterparties to exchange a series of cash flows at specified settlement dates in the future. Swaps are entered into through private negotiations to meet each firm's specific risk-management objectives. There are two principal types of swaps: interest-rate swaps and currency swaps. Today interest-rate swaps account for the majority of banks' swap activity, and the fixed-for-floating-rate swap is the most common interest-rate swap.

In such a swap, one party agrees to make fixed-rate interest payments in return for floating-rate interest payments from the counterparty, with the interest-rate payment calculations based on a hypothetical amount of principal called the notional amount. Many financial experts, bankers and corporations Chief Executive Officers (CEO) have asked whether the Congress and regulators should allow corporate to synthetically modify the structure of their assets and liabilities.

To get a clear answer, we must look closer and compare the two types of interest rates and weight the pros and cons of each. Fixed rate liabilities to Floating rate liabilities are a diversified funding mix of total liabilities that matches the liabilities equal to assets, (especially if a company has large amounts of cash). Where as floating rate liabilities to fixed rate liabilities lock in known costs of borrowing and reduce interest rate volatility (Curtis L. Norton, 2010).

To this point, interest rate swaps can be viewed as a highly effective tool for firms to generate assets while hedging against interest rate exposure. However, due to loose regulations on underlying contracts between two parties derivatives were considered to be "non-transparent." Question of ethical conduct became a factor in trading as well as, a demand for a market to regulate over-the-counter (OTC) derivatives.

The market is by far the most popular way of exchanging interest payments between two parties and has as estimated worth of "U.S.$342 trillion." It is estimated that "more than 90% of Fortune 500 companies" tailor individual over-the-counter derivatives every day. These firms involved in OTC derivative trading are now required to raise standards on "trading platforms" resulting in an increase of costs, while proving to slow the pace of the market making it difficult for smaller companies to meet expectations.

Before going any further, one must understand why Congress has had to enforce stricter guidelines when trading derivatives after the financial crisis (David Henley, 2000). Rationality of Economic Mismanagement The housing bubble which projected the financial crisis was purely because of irrationality (Akerlof and Shiller, 2009) the crisis would have been light if there were existing rationality.

Economists are aware of the external and agency costs that occurs when one party acts "rationally" -- that is, in his or her own best interests -- and that action has an adverse effect on another party or parties, the cost to others will be far greater than the benefit to the decision-maker hence agency conflicts that arise between corporate managers, stockholders and bondholders.

Both the theory for and empirical examples of "looting," defined as the taking of other people's money while the guarantor (usually the government and by extension, its taxpayers) is left to pay the cost (Akerlof and Romer 1993). Such instances of looting are especially common in climates of "poor accounting, lax regulation, or low penalties for abuse." (Jensen and Meckling, 1976). Financial derivatives though provide relatively cheap and precise ways for firms to hedge risk, unfortunately also provide new opportunities for agency conflict.

Mixed evidence has been gathered on whether stock options induce managers to increase their firms' risk or engage in other practices that are detrimental to shareholders; agency costs had a very real effect in the recent widespread securitization of mortgages. The practice of "shopping for ratings," which entails three separate types of agency problems, first, the ratings that were given to a bank's portfolio of mortgage-backed securities often depended on the bank's own models.

Thus, the banks had more flexibility in determining the outcome than if the ratings had been determined externally, second, the rating agencies' compensation was often paid by the very banks whose securities they were rating, third, the existence of multiple rating agencies, all in competition with one another, led to a "race to the bottom" whereby the agency that lowered its standards the most would get rewarded with the banks' business (Johnson and Kwak, 2010).

Credit default swap (CDS) is an instrument that pays out money if a borrower experiences default or some other credit problem. However, credit default swaps are often regarded simply as insurance on debt (the periodic payments made from the buyer of the CDS to the seller are even called "premiums"). Unlike traditional insurance products, however, the buyer of a credit default swap need not be the lender of that debt nor have any "insurable interest" in it at all.

Therefore, even though CDSs were treated by regulators purely as hedging instruments, they could be used for speculation as well, meaning that the institutions that invested in CDSs were allowed to subsequently reduce their risk-based capital requirements even though the overall risk in their portfolios had in some cases increased (Stout and Knowlton, 2009). Managers have an incentive to externalize risk. In the absence of information and regulation, the incentive increases.

The recent past has borne witness to these new types of financial derivatives such as CDSs which were created as the securitization boom peaked. The newness and complexity of these derivatives require extensive oversight and regulation, but the climate has been hostile to those needs. To understand the basic problems that underlie such crises improves our chances of preventing them from occurring again in the future, and of mitigating the damage when they do occur.

Previously, financial derivatives were regarded as "loosely regulated." The Commodity Futures Modernization Act of 2000 was passed by Congress on December 15th, 2000 and signed into law by President Clinton on December 21st, 2000. The "Act" contains stipulations with regards to the regulation of the Commodity Futures Trading Commission (CFTC) as well as the Securities and Exchange Commission (SEC). The "Act: turned out to be non-affective as it allowed a majority of derivatives to escape the U.S. federal regulation. A vivid example of such organization is AIG Inc.

who experimented "heavily in derivatives." In order to prevent another financial scare Federal officials, such as Treasury Secretary Timothy Geithner was recorded saying, "he intends to bring derivatives into the regulatory orbit." His idea was to tighten federal regulations, primarily CDS markets.

Joel Telpner, a derivative lawyer at Mayer Brown in New York said, "…reporting those positions will address the primary concerns of the market, about who is trading what derivatives." During this time the biggest concern was still what it was before the collapse and that was Credit Default Swaps ( Probably the biggest factor to the crisis of 2008 was due to Credit Default Swaps (CDS), which caused the housing bubble resulting in an economical recession for the last four years -- looking forward.

To understand this recession one must understand the phrase itself. Credit is a loan consisting of bonds, consumer loans, or mortgages. The loan must be repaid over a predetermined period of time in order for investors to make money over the spread. What happens when the borrower cannot pay back the loan? This is considered a default risk. If a borrower were to default, this results in a loss of principle for the investor. For some investors this is fine because they are speculators.

For other investors who are conservative for example, a pension fund that might want to invest in a debt/mortgage market they might not feel this is an acceptable risk for their clients. So what can an investor do to protect against the risk of default? A swap is a contract to make an exchange in the future if events occur. Credit Default Swaps (CDS) are considered to be one of the most complex financial instruments in the market of derivatives. CDS is an insurance protection against default.

The seller of the CDS is the insurer who takes on risk and the buyer is the policyholder who is reducing that risk. In return the buyer will pay the seller some cash up front similar to an insurance premium. The Credit value (value of loan underlying) will determine the price and value of the CDS. The problem is that the relationship is unclear because of a complex equation with often hundreds of thousands of dependencies and complex inputs and variables and as a result, it is very hard.