In the essay the author discusses some of the most important risks and threats of using financial derivatives by explaining them. The essay deals with questions like: Are financial derivatives really a threat for firms and, worse, for the whole economy? Do they increase welfare? If yes, who benefit the most? Are there losers?
Warren Buffet, without any doubt one of the most famous investors of the world, once referred to financial derivatives as “Financial weapons of mass destruction”. Ed Murray, practicing lawyer and senior member of the Allen & Overy team advising ISDA (International Swaps and Derivatives Association), states that derivatives played an important role and worsened the Financial Crisis.
Many more influential people seem to point accusing fingers to financial derivatives, stating that derivatives may bear significant problems people are underestimating. Since the derivatives market have been growing immensely since the 1970s to todays unbelievable estimated notional value of 1,2 quadrillion US dollars, more than ten times the gross world product (107,5 trillion US dollars), financial derivatives play an extremely important and growing role in todays financial system. Therefore we should be aware of the problems, risks and threats coming with the usage of derivatives instrument.
Table of Contents
- Are Financial Derivatives Good or Bad?
- Basic Knowledge about Financial Derivatives
- The Subprime Crisis and its Relation to Financial Derivatives
- Leveraging, Incentives, and Counterparty Risk
Objectives and Key Themes
This essay aims to analyze the risks and benefits of financial derivatives, addressing whether they pose a threat to firms and the economy as a whole. It explores the welfare implications, identifying beneficiaries and potential losers. The analysis will ultimately conclude on whether financial derivatives are ultimately beneficial or detrimental.
- The inherent risks of financial derivatives, including counterparty risk and leverage.
- The role of regulation (or lack thereof) in exacerbating the dangers of derivatives.
- The impact of perverse incentives on risk-taking behavior in the financial industry.
- The use of derivatives for hedging versus speculation.
- The overall welfare implications of financial derivatives, considering both gains and losses.
Chapter Summaries
Are Financial Derivatives Good or Bad?: This introductory chapter sets the stage by referencing prominent figures like Warren Buffet who have expressed concerns about the risks associated with financial derivatives. It highlights the massive size of the derivatives market and the need for a critical analysis of its potential dangers. The chapter introduces the central question of whether derivatives ultimately benefit or harm the financial system and sets the framework for the subsequent examination of key risks and issues.
Basic Knowledge about Financial Derivatives: This section provides a foundational understanding of financial derivatives, defining them as instruments deriving their value from underlying assets such as stocks, bonds, or commodities. The chapter differentiates between over-the-counter (OTC) and exchange-traded derivatives, emphasizing the higher risks associated with the largely unregulated OTC market. It explains basic derivative types like forwards, futures, call options, and put options, highlighting their historical use for hedging purposes and their modern application in speculation. The discussion lays groundwork for understanding the complexities and potential for misuse in later sections.
The Subprime Crisis and its Relation to Financial Derivatives: This chapter analyzes the role of financial derivatives in the 2007 subprime crisis. It describes how the securitization of risky mortgages into collateralized debt obligations (CDOs) and the use of credit default swaps (CDS) as insurance against CDO defaults contributed to the crisis. The chapter explains how the unregulated nature of these derivatives allowed for excessive risk-taking and the creation of a system where the number of bets on defaults far exceeded the actual underlying assets. The failure of AIG, a major insurer of these CDS, is presented as a key example of the systemic risks associated with the unregulated derivatives market, highlighting the interconnectedness of the financial system and the potential for rapid contagion.
Leveraging, Incentives, and Counterparty Risk: This chapter focuses on three critical issues that amplify the risks associated with derivatives: leveraging, perverse incentives, and counterparty risk. The chapter explains how leveraging allows investors to amplify their potential profits but also increases potential losses exponentially. It discusses the role of perverse incentives, arguing that executives in financial institutions may take excessive risks due to the lack of sufficient consequences for poor decisions. The lack of proper regulation and reserve requirements, as illustrated by the AIG bailout, is presented as a major contributor to the counterparty risk inherent in over-the-counter derivatives. The combination of these factors is argued to create a dangerous and potentially explosive situation within the global financial system.
Keywords
Financial derivatives, risk management, hedging, speculation, leverage, counterparty risk, regulation, subprime crisis, systemic risk, perverse incentives, welfare, AIG, OTC markets, credit default swaps (CDS), collateralized debt obligations (CDOs).
Frequently Asked Questions: A Critical Analysis of Financial Derivatives
What is the purpose of this document?
This document provides a comprehensive overview of financial derivatives, analyzing their risks and benefits. It explores the role of derivatives in the 2007 subprime crisis and examines key themes such as leverage, counterparty risk, and perverse incentives. The ultimate goal is to determine whether financial derivatives are ultimately beneficial or detrimental to firms and the economy.
What are the key themes explored in this analysis?
The key themes include the inherent risks of financial derivatives (counterparty risk and leverage), the impact of regulation (or lack thereof) on these risks, the influence of perverse incentives on risk-taking behavior, the distinction between hedging and speculation using derivatives, and the overall welfare implications, considering both gains and losses from their use.
What types of financial derivatives are discussed?
The document covers basic derivative types such as forwards, futures, call options, and put options. It also discusses more complex instruments like collateralized debt obligations (CDOs) and credit default swaps (CDS), highlighting their role in the subprime crisis.
What is the significance of the 2007 subprime crisis in relation to financial derivatives?
The analysis delves into the role of financial derivatives in the 2007 subprime crisis, explaining how the securitization of risky mortgages into CDOs and the use of CDS contributed to the crisis. It highlights how the lack of regulation allowed for excessive risk-taking and created a system where bets on defaults far exceeded the underlying assets. The failure of AIG is presented as a key example of systemic risk.
What are the key risks associated with financial derivatives?
The key risks include counterparty risk (the risk that the other party in a derivative contract will default), leverage (the use of borrowed funds to amplify potential profits and losses), and perverse incentives (situations where individuals or institutions are incentivized to take excessive risks). The lack of sufficient regulation and reserve requirements is also identified as a major contributor to these risks.
What is the difference between hedging and speculation using derivatives?
The document distinguishes between the use of derivatives for hedging (reducing existing risks) and speculation (taking on risks to profit from market movements). While derivatives can be used for legitimate hedging purposes, their application in speculation can significantly amplify risks and contribute to market instability.
What are the overall welfare implications of financial derivatives?
The document aims to analyze the overall welfare implications of financial derivatives, assessing both the potential benefits and the significant harms. It seeks to determine whether the benefits outweigh the risks, considering the potential for systemic crises and the distribution of gains and losses among different stakeholders.
What is the conclusion regarding the overall benefits and drawbacks of financial derivatives?
The document does not explicitly state a definitive conclusion on whether financial derivatives are ultimately beneficial or detrimental. However, the analysis thoroughly examines the risks and benefits, providing the reader with the information needed to form their own informed opinion.
What are some of the key keywords associated with this analysis?
Key keywords include: Financial derivatives, risk management, hedging, speculation, leverage, counterparty risk, regulation, subprime crisis, systemic risk, perverse incentives, welfare, AIG, OTC markets, credit default swaps (CDS), collateralized debt obligations (CDOs).
- Quote paper
- Sinan Tunbek (Author), 2016, Are financial derivatives good or bad? Benefits and threats of using financial derivatives, Munich, GRIN Verlag, https://www.grin.com/document/471031
