Understanding derivatives and financial risk management in global markets

Risk Management

CSLO

The reason why it is important to understand the role of the financial markets is: because of globalization. As, this has caused shifts in: the economy and the way people are interacting with each other. One way to effectively comprehend what is taking place is with, the indices reflecting how these transformations are impacting the world economy. This means that ordinary people need to have an: understanding of the markets and the way they are reacting to various events. This will help them to determine, what will occur in the economy over the next nine months to one year. As, prudent individuals can begin to plan on: profiting from these changes or they could protect their assets. In either case, understanding the markets in this aspect will help everyone to more effectively prepare for uncertainties. This is how you can be able to increase your net worth and protect it during times when it could be facing severe challenges (i.e. bear markets).

The way that I was able to learn about derivatives and the role in the economy is seeing there long-term effect. As, these instruments have been used as an effective way of helping to mitigate risks in the market (i.e. hedging). However, the last several years have meant that more investors have become involved in these areas. Their main objectives are to increase their overall return and reduce their risks dramatically.

Yet, they do not understand the possible risks and the impact that it could have on their portfolio. This is because the use of derivatives, have become so common in the markets that most people assume that they are invested safe areas (without investigating them further). The reason why is because this asset class has been utilized so much, that is now of part of modern portfolio thinking. This means that these kinds of investments are: one way that a number of institutional and individual investors are trying to diversify their holdings. The problem is that globalization can take a risky investment and spread it around the world. If there is a bubble in a particular area, this could cause investors to take larger risks without realizing what is happening. At which point, they are exposed to changes in the economic cycle. Once this occurs, it means that they could see dramatic losses in their portfolio.

A good example of this can be seen with the recent financial crisis. As, derivatives were at the heart of the tranches that were: sold to investors of subprime mortgages. This is when the investment banks, bundled a number of high profile mortgages together. The idea was to: reduce the risks of default and increase the total return that they were providing.

Prior to 2007, many investment bankers claimed that the risks were reduced because of: the pool (i.e. tranche) and could they could purchase put options to protect themselves. The problem was that there were no public markets, where these products were trading and no one understood the true value of them. This made purchasing any kind of puts difficult.

Once the economy began to slow, investors were left holding assets that could not be sold and there was no way to accurately value them. What made the situation worse is that large financial institutions (i.e. banks) began to face liquidity problems. This is because they were holding, a large number of these assets on their balance sheets. Since this there was no way to accurately value or sell them they were essentially worthless (creating a liquidity crisis). This experience shaped my views of derivatives and their role in the economy. As, they are a great way to be to: provide protection (if they are used properly). However, during bull markets and times of strong economic expansion, is when the risks increase exponentially. Therefore, some kind of balance and common sense needs to be used when becoming involved in this particular asset class.

The role of buying and selling assets is based off of the laws of supply and demand. This means that there will be times when you will have excessive demand (bull markets) and supply (bear markets). These forces will cause the indices to overreact in both directions. This is due to the fact that excessive supply is pushing the markets beyond normal valuations. Once this begins to happen, is when investors need to be prepared for sudden changes. As, they must use strategies (such as: hedging) to protect their portfolio. While at the same time realizing, that bubbles or extreme slowdowns can linger for a period of months to years. This is why the markets are constantly going between: various phases of contraction and expansion over long periods of time. If the prudent investor can understand these factors, they will be able to avoid becoming influenced by: irrational pessimism or exuberance.

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The reason why it is important to understand risks is because, of the changes that have been occurring in the world of investing. This has caused the total number of threats facing investors to rise dramatically. In order to understand the world that we live in and how to account for possible uncertainties requires recognizing these hazards. Otherwise, anyone who fails to understand risk and its dynamics, are at the mercy of events that are occurring. This can have devastating consequences on the lives of individuals and their families. Where, if they are not prepared for sudden changes; they could have an adverse impact on their standard of living and economic well being. Therefore, everyone needs to realize these risks and how to account for them.

Financial risk management was learned through seeing actual events unfolding in the markets. As, managers made decisions that were: ill advised and had a negative impact on their business. This is because they did not fully understand these dangers. This influenced my thinking by serving as a cautionary tale about how to understand the hazards a corporation is facing.

A good example of this can be seen with Enron. What happened was: the different actions that managers were engaged in, did not take into account the risks of various projects. This caused the company to face cost overruns, to the point that it began to impact their balance sheet. To hide these losses management began to create special purpose entities. This led to the accounting scandal, because managers did not plan for risks on the various projects they were involved in. These events shaped how I would view risks and the importance of comprehending strong management techniques to mitigate these effects.

Understanding financial assessment is when: you can take various ideas that were presented and can make an accurate determination about investment decisions. This helps to make financial planning more effective.

However, over the last several years the competitive environment internationally, has meant that a shift has occurred. This has caused the total amount of financial information that is available to increase. The reason why, is because the competitive environment is causing more information to be made available to the public. Over the course of time, this can create confusion for some people as they have too much information available (which leads to indecision). When you are able to understand financial assessments, this will help you to effectively sort through the various pieces of information. Where, you have the knowledge and the experience to know what resources are the most valuable (over other pieces that you are looking at). In the competitive international environment, this approach is necessary for making the most informed decisions (based on all available information).

The seller's and the buyer's risks are not the same. The reason why is because, the objectives are different between the two parties. As, the buyer wants to: receive the product or services that they require at a fair price. While the seller, is trying to increase their profit margins from delivering these products and services to customers.

This creates a conflict between the two when it comes to risk. From the perspective of the buyer, they want quality and reasonable prices. When they do not receive what they paid for is when the risks increase for this party. This is due to the fact that they are using the product or service to address a specific need. While the seller, wants to increase their profits and reduce costs. From their viewpoint, the risks are based on: lower profit margins or possible losses in selling the product. This is significant, because it showing how the two perspectives for risk are not the same.

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Understanding the use of the currency contract will help business and individuals to account for possible risks they will face. This usually occurs with a business conducting trade or a person encountering these issues when they are traveling. These two factors have become a major part of the global economy. With the ability, to go from: one country to the next and free trade becoming the areas of focus for most governments. This means that they will enact policies that will encourage more people to travel to their region and trade with local businesses. Over the course of time, this has created a shift in the importance of the currency contracts. As, they are used as a way to reduce risks from: the volatility in the movements of the numerous currencies contracts. When you understand how this asset class works, you can be able to account for possible risks and increase your profit margins from the instability in prices.

Commodities futures are an effective way for investors and businesses to be able to efficiently price the costs of various natural resources. This helps to: improve transparency and trade by ensuring that everyone has easy access to the markets. Over the course of time, this will allow the economy to grow by: providing an effective mechanism of trading a host of commodities. This makes business more productive, as they can respond to changes in the costs of raw material in real time. For the consumer, this is providing them with a large assortment of products to choose from at affordable prices.

A good example that shaped these experiences was the increases in the cost of crude oil in 2008. At the time, many of the pundits claimed that businesses could handle higher costs of commodities. The reason why is because, demand was strong from many Asian countries. However, as prices continued to climb higher this began to have an impact on wholesale costs. As, manufacturers began to pass: the large cost increases in commodities prices to their customers. Once they reached above $120 per barrel is when many consumers began to feel these effects. At which point, they began to cut back on their spending (which helped to fuel the recession). This is important, because it shows how understanding commodity futures will help to: provide insights about the overall strengths or weaknesses associated with economic activity moving forward.

Understanding energy and housing futures will provide specific insights as to the underlying strengths of the economy. This is because these two areas are: an important part of daily life for everyone. As, they have an inverse relationship with one another, which will have an impact on the economy. When you see energy prices rising, this will have an impact on housing futures with consumers having less money to spend. While a decline in energy prices and an increase in home values will fuel an expansion in consumer spending. This is because prices are low and the higher values, from real estate are making consumes feel wealthier. When you put these elements together, they are showing how understanding the relationship between them, will provide insights about the strength of economic activity.

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Derivatives can be misused to create the impression, that a particular asset class is a safe investment. When in reality, it could be increasing the overall risks that: individuals or institutional investors are facing. This is problematic, because it can allow for large asset bubbles to develop and the false belief that everyone is protected.

However, once the bubble bursts is the point that the underlying risks are evident. As, these individuals can only receive a fraction of the value that they paid for their original investment. This is the point, that the actions of speculators can have ripple effects on the economy as whole. Where, large institutions could be involved in the same kind of activities and they have no capital reserves. Once this occurs, the odds increase that you could see the liquidity positions of these institutions placed in jeopardy. This is the point, that a hedge fund (i.e. long-term capital management in 1998) could have ripple effects on the entire financial system. As, it is raising the possibility, that there could be some kind financial crisis that will cause the credit markets to freeze. This is significant, because it is illustrating how derivates can be misused. Therefore, there needs to be a balance between the activities of speculators and various regulations that are in place. If this kind of an approach can be taken it will help to prevent the possible abuses of derivatives in the financial markets.

What derivatives have shown about managing personal and corporate risks is: that they need to always be taken into account. The reason why, is because this kind of a tool can be utilized to protect against uncertainty. However, the use of derivates by themselves is considered to be the most speculative type of investing. The reason why, is because you can lose your trading capital in the position. This is important, because understanding this risk will help you to utilize this strategy to: effectively protect the portfolio and increase the overall returns.

As a result, personal and corporate investing requires understanding this fact. However, if the strategy is utilized wrong it is increasing the overall risks. As a balanced approach must be taken, that will allow investors to be able to effectively address these risks and increase their profits. This is the key in being able to maintain this kind of philosophy during bull and bear markets. As, it easy to be influenced by: the forces of greed or extreme pessimism (which will have an impact on the kinds of decisions that being made).

Possible strategies that are available for effective risk management include: using multiple derivatives tools and limiting areas of your portfolio that are exposed to risk. The use of multiple derivatives strategies is when you are utilizing different tools that can mitigate the various risks. For example, many investors will often use straddles on the major market averages to protect themselves against volatility. At the same time, they will use hedging to ensure their different stock positions are safeguarded against sudden shifts in prices. This is important, because it is showing how investors will often use a variety of different options strategies to address specific risks in their portfolio. If utilized properly, this will effectively limit their downside. While at the same time, it is increasing the total return that they are seeing. As, this is striking a perfect balance between: the underlying risk to reward ratio in the market.

Limiting areas of your portfolio that are exposed to risk, is when you will allow a percentage to be invested in other areas that are considered more speculative. The basic idea with this approach is that if something happens, the negative consequences would be minimal. The reason why is because the majority of your assets are concentrated in safer areas (which reduces the risks that you are facing). If this kind of approach can be used in conjunction with multiple derivatives strategies it will reduce the risks in the portfolio. This will allow you effectively mitigate the underlying risks and increase the return.