With Reference to the 2007 Global Financial Crisis, Explain the Pitfalls Associated with Derivatives

Topics: Derivatives, Credit rating, Futures contract Pages: 7 (2199 words) Published: August 3, 2013
Introduction This essay explains the pitfalls associated with derivatives instruments by making reference to the 2007 Global Financial Crisis. Derivatives are financial securities that are linked to a specific instrument or indicator or commodities called underlying instruments (Hull, 2009). There are as many derivatives as they are underlying instruments. Derivatives are essentially financial contracts which are entered into between two parties with respect to some other underlying instruments. Since they are contracts entered into with respect to underlying assets they do not have value on their own standing but derive it from that of instruments upon which they are entered into. According to the IMF (2010), even though it’s true that derivatives are linked to the value of underlying instruments, transactions in derivatives are separate transactions from those of underlying instruments upon which derivatives are based. This means that derivatives are financial securities with own roles, advantages and disadvantages which are distinct from those of underlying instruments.

The 2007 Global Financial Crisis There are a number of causes attached to the global financial crisis that saw the meltdown of many financial institutions around the world. For the purpose of this essay we consider one of those causes which is linked to trading in derivative instruments. According to Ellis (2009) the misperception and mismanagement of risk is one of those causes. This misperception and mismanagement of risk particularly refers to issues which surrounded mortgage backed securities (MBS) on the wake of the crisis. Mortgage Based Securities are derivatives because their value is secured, or backed, by the value of an underlying bundle of mortgages. The boom in the housing market in the U.S. accentuated the use of derivatives (MBSs). However, most derivative users did not comprehend these instruments to an extent that they never really understood the risk they were assuming by using these instruments. Credit rating agencies inappropriately rated derivative instruments such that they failed to reflect their true market price and the risk associated with them. The end result was that most participants who had huge positions in these instruments under-estimated their risk exposure resulting in the collapse of financial institutions around the world such as Lehman Bank and causing a dry up of credit due to increased risk perception which negatively affected real macroeconomic variables worldwide.

The pitfall of derivatives and the 2007 Crisis Dating as far back as 1865 (Greenberger,2010), derivatives have grown in usage starting with futures to more recent and sophisticated derivatives such as Credit Default Swaps (CDSs), Mortgage Backed Securities (MBSs) and Credit Default Obligations (CDOs). Prior to the financial crisis, there was ignorance about the dangers associated with these ‘’alien’’ instruments. Even though their potential threat was raised by others (Buffet cited in McClean.n.d), who called them “weapons of mass destruction” the investment world ignored that warning mainly because of the belief that good times would last to perpetuity. In this section we will discuss the pitfalls of derivatives instrument with reference to the 2007 financial crisis. Derivatives contracts involve counterparty default risk. This is because these instruments differ from other financial assets in the sense that they are contracts which involve long-term exposure which may last for several years (European Commission, 2009). For example in forward contracts, one party (the buyer) agrees today to buy a certain asset in the future and the other party (seller) agrees to deliver that asset at that point in time. This leads to the build-up of huge claims between counterparties, with the risk of a counterparty defaulting (Lartey, 2012). This means that derivatives are inherently more risk instruments than other financial assets. The counterparty default...
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