Wednesday, February 11, 2009

Derivatives- Means To Mass Destruction!!!

In Capital Markets, there have been many ways to multiply your profit, in recent times the craving in this direction has increased heavily.

Derivatives have been in the industry for almost 3 centuries. The financial derivatives came into spotlight in post-1970 period due to growing instability in the financial markets.

Derivative is a product whose value is derived from the value of one or more basic variables, called underlying. The underlying asset can be equity, index, foreign exchange (forex), commodity or any other asset.
Derivatives can be essentially used to diminish or tone down the risk of economic loss arising from the changes in the value of the underlying.

Because the value of a derivative is contingent on the value of the underlying, the notional value of derivatives is recorded off the balance sheet of an institution, although the market value of derivatives is recorded on the balance sheet.

Uses of Derivatives are in Hedging and Speculation and Arbitrage.

Hedging

Derivatives allow risk incurred in the value of the underlying asset to be transferred from one party to another. Such a mechanism is know as Hedging.
We can say a buyer and seller can sign a contract about a particular value of an asset in future(The value is speculated for future value on the basis of the market and demand forecasting in future).

Hedging also occurs when an individual or institution buys an asset (like a commodity, a bond that has coupon payments, a stock that pays dividends, and so on) and sells it using a futures contract.

Speculation and Arbitrage

Derivatives can be used to acquire risk, rather than to insure or hedge against risk.
Speculation means Implied Gambling(Gambling with some results favoring it). Individuals and Institutions enter into a derivative contract to speculate on the value of the underlying asset, betting that the party seeking insurance will be wrong about the future value of the underlying asset.

Individuals and institutions may also look for arbitrage opportunities, as when the current buying price of an asset falls below the price specified in a futures contract to sell the asset.
Arbitrage means Intermediate Market conditions.
An example can be-
There is always a difference in price of Shares in NSE and BSE. Some people may buy Shares in NSE and sell them in BSE if the value is more(earning profit excluding minor transaction charges).
Arbitrage is no loss work which has become a famous undertaking in recent times.

Criticism

Warren Buffet once said "Derivatives are a means of Mass Destruction"
, clearly the saying goes with the happening. The Tornado of Economic Recession which is DESTRUCTIVE and still going on has been the, u can say "EYE WITNESS", of the above saying.

Derivatives massively leverage the debt in an economy, making it ever more difficult for the underlying real economy to service its debt obligations and curtailing real economic activity, which can cause a recession or even depression.

The use of derivatives can result in large losses due to the use of leverage, or borrowing. Derivatives allow investors to earn large returns from small movements in the underlying asset's price. However, investors could lose large amounts if the price of the underlying moves against them significantly.

There have been instances of massive losses in derivative markets such as-
1. The need to recapitalize insurer American International Group(AIG) with $85 billion of debt provided by the US federal . An AIG subsidiary had lost more than $18 billion over the previous three quarters on Credit Default Swaps (CDS) it had written. It was reported that the recapitalization was necessary because further losses were foreseeable over the next few quarters.

2. The bankruptcy of Orange County, CA in 1994, the largest municipal bankruptcy in U.S. history. On December 6, 1994, Orange County declared Chapter 9 bankruptcy, from which it emerged in June 1995. The county lost about $1.6 billion through derivatives trading.(Courtesy: Economic Times) Orange County was neither bankrupt nor insolvent at the time; however, because of the strategy the county employed it was unable to generate the cash flows needed to maintain services. Orange County is a good example of what happens when derivatives are used incorrectly and positions liquidated in an unplanned manner; had they not liquidated they would not have lost any money as their positions rebounded. Potentially problematic use of interest-rate derivatives by US municipalities has continued in recent years..................

2 comments:

ankit said...

i guess greed is a major reason to mass destruction and derivatives provide instant fuel to this fire of greed.

yes, u have shown with your examples, tho derivatives can bring about fast and quick money, in long run for institutions, it may create financial troubles, in the event of a downturn!

vinitsays said...

Ankit,

I completely agree with ur opinion.

yes if taken in a less planned manner they can lead to huge losses in future.

What I think is that many of those who use derivatives don't exactly know the steps to be taken or the manner in which these are to be taken.

So its not the properties of derivatives that are bad, but its the way in which we employ them.