“The International Swaps & Derivatives Assn. recently estimated the worldwide market at $ 105 trillion. The Office of the Comptroller of the Currency (OCC) says U.S. commercial banks held $ 56 trillion of derivatives at the end of 2002”, and by comparison the GDP of the US was estimated to 10.4 trillion the same year.
The world’s largest financial market today is therefore without doubt the derivative market. Derivatives have come into existence because nearly every business has its risks. Derivatives are used to protect against key-business risks which are beyond our control, such as movements in the markets of commodities and foreign exchange . Those who use derivatives as a way of managing risk are called hedgers. Martin Taylor, former Group Chief Executive of Barclays, compare risk with energy; “Risk is neither created, nor destroyed, merely passed around.” This is where the speculators play an important role in the derivatives market. The speculators have no interest in the underlying itself, but for the possibility of a reward they are willing to accept a certain level of risk. Without the speculators the derivatives markets would not function. The third group of players in this market is the arbitragers. These people look for mis-pricing and market mistakes, this give them a risk-free profit, a situation that gets the mistakes to disappear before becoming too large. After a number of huge derivative losses in the mid-nineties, a lot of criticism was pointing at the derivative trading. For example, Orange County lost $1 billion in SWAPS contracts and went bankrupt, Barings Bank shut down business after a £880 million loss caused by futures trading in Singapore.
In this essay, I will look at both the upsides and downsides from the use of derivative instruments, mainly focusing on exchange traded derivatives. Different user groups such as private investors, companies, banks and traders, will be taken into account. In addition, I will discuss whether there is a need for further restriction of the derivatives market or not.
According to several financial institutions, derivatives are not as risky as many fear. When the right derivative instrument is used prudently by qualified people, they can lead to benefits. On the other hand, derivatives are extremely powerful financial instruments, charged with a high degree of leverage, and carries a substantial level of risk. Small movements in the underlying instrument can result in very large swings in the products price, ending with great gains or losses. Institutions can reduce funding costs by, for example, purchasing debt in the market where they have comparative advantage, and entering into either a currency- or an interest rate swap to receive the required debt type. Derivatives can, as mentioned earlier, also be used to hedge exposures. For example by entering in to a forward- or a future contract, foreign exchange risk can be reduced or almost eliminated. An investor worried about losses on portfolio investments in stocks or bonds can use derivatives to define the downside. Hedging a portfolio can be done by buying/selling options on an index, in the case of UK, the FT-SE share index. One can also hedge by simply buying a put option for one particular share. The Index futures and options are commonly used by equity funds; it is especially useful when market volatility is high or in a bear market. This is a form of insurance, for which the investor has to pay a premium. There are several strategies investors can undertake when making use of options, depending on the view of the future movements in the market and their attitude to risk. Strategies in an option market are for example Protective puts; buy put options on the underlying you owe to cover for short-term fall in price. Covered calls; write a call at the underlying you own to increase potential profits if the market does not move and at the same time be protected against a fall in the underlying....
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