Wait a second!
More handpicked essays just for you.
More handpicked essays just for you.
Derivative financial instruments
Don’t take our word for it - see why 10 million students trust us with their essay needs.
Recommended: Derivative financial instruments
Derivatives, also known as futures contracts, are financial instruments whose value is derived from an underlying asset (Sivy, 2013). They are bets between two parties with the payoff based on a future value of the asset and can be derived from fluctuating things such as interest rates, stock indexes, mortgages, or even the weather (Rickards, 2012). Warren Buffet comments that, “we view derivatives as time bombs, both for the parties that deal in them and the economic system”. I agree with his statement because derivatives are complex and unstable. There is no telling when they could explode causing another financial crisis. Although there were numerous factors that contributed to the recent financial crisis, derivatives like mortgage backed securities (MBS) and collateralized debt obligations (CDOs) had a strong impact on the events that transpired. In the MBS market, the cash flows from a mortgage is broken up into different parts and then sent to whoever can best handle the different risks at the best price. These parts are then repackaged into new financial instruments which are sold to investors (Rickards, 2012). The new portfolios were used to back collateralized debt obligations (CDOs) which were divided into tranches and sold to investors (Hull, 2011). These portfolios were guaranteed by the government national mortgage association (GNMA) which allowed banks to lend money without worrying about borrowers defaulting on their loans. Banks were able to generate profits from lending out their money. The securities created from the risks allowed banks to make money without keeping the risk on their balance sheets. As more loans were taken out to buy houses, the house prices rose and lenders had to introduce low teaser rates t... ... middle of paper ... ... long term call options which would either profit or expire worthless. Goldman never explained the transactions until after they were made and had to be pursued for information on the trades. Banks like JPMorgan and UBS have experienced the cost of what happens when you go into derivative trading. The derivatives market is extremely complex and not transparent. Since most of the trading is done over the counter, it is difficult to determine the actual value of the market. The entire market is supported by a small amount of cash, so if it were to crash the losses could add up to more money than the world has. The financial crisis should have been a warning to reduce the use of derivatives but instead it has grown. With that in mind, derivatives can be seen as time bombs. It’s only a matter of time before the next financial crisis happens at the cause of derivatives.
After the time of financial crisis, JP Morgan was not the only national bank in US which got involved in trade of toxic loans related to mortgage. Before JP Morgan, it was Goldman Sachs-another large US Bank that faced the allegation of manipulating the trades in its own self interes, ended up in favor of SEC while GoldMan Sachs were asked to pay $500 Million during late 2011 in a deal called Abascus 2007-AC1 where the bank were alleged to mislead its investors on a deal related to Collateral Debt Obligation(CDO). (Eaglesham, 2011) The ab...
Sale of the securities at the earliest: JP Morgan followed the herd. JP Morgan only saw the profits that were coming and not the long term losses it was incurring. They should have sold their securities the moment they realized that the market is going down.
On the other hand, they adopted a so call self-expansion way to avoid risks. Mortgage companies used securitization to transfer the underlying assets of subprime mortgage into mortgage backed securities (MBS) and transferred the risk from their balance sheet to individual or institutional investors. Once the risk had been transferred, the money that these companies could lend increased. In other word, it strengthened their loan capacity. The more money released from the loan by securities, the lager capacity that the companies gained. Thus, securitization seemed to offer mortgage companies with infinite
Did you know tobacco and alcohol use cause over 475,000 deaths in the U.S. annually? To assist young people in avoiding these harmful behaviors, the D.A.R.E. program enhances the knowledge and awareness of the hazards regarding dangerous substances throughout a ten week program. The acronym D.A.R.E. stands for drugs, abuse, resistance, and education. D.A.R.E. ensures the safety of adolescents in various situations and instills beneficial strategies, techniques, and tips to aid young people in making responsible decisions.
Years of cheap credit, combined with government incentives to get people to purchase homes, debt securitization that hid the risk of low quality loans, and Government Sponsored Entities (GSEs) that lowered standards for purchasing mortgages created a situation that compelled lenders to make riskier and riskier loans. Individuals who had formerly not been able to purchase homes had access to credit like never before. With more and more people buying houses, prices soared and real estate looked like a sure-fire way to make money. Adjustable rate loans or loans with a huge balloon payments were not seen as potentially unaff...
Historically, banks link savings to investment. Deposits are paid in by savers, the bank’s liabilities, some of that money is held in capital reserve and the rest is lent to businesses and entrepreneurs as loans, the bank’s assets. The savers will be paid interest on their deposits, and the enterprises will have to pay interest on their loans, higher than the interest paid to depositors; the difference in interest is the banks revenue. This is a fairly mundane business model which banks have been doing for over 600 years. Recent declines in interest rates have led to decreased profit margins on this type of intermediation. Banks needed to diversify, and the deregulation of UK banks in 1986, and the emergence of light touch regulation, allowed them to do such. Retail banks from here on offered services such as mortgages, pension plans and insurance. Investment banks, traditionally offering corporate services like merger and acquisition advice, now operate in proprietary trading in wholesale markets. OECD reports that non interest income accounts for 40.7% of credit institutions income in 2003, up from 25.5% in 1984. All this change in how banks operate, fuelled by declining margins and self-regulation, has led to the us...
On the night of Monday, October 21st, 1929, margin calls were heavy and Dutch and German calls came in from overseas to sell overnight for the Tuesday morning opening. (1929…) On Tuesday morning, out-of-town banks and corporations sent in $150 million of call loans, and Wall Street was in a panic before the New York Stock Exchange opened. (1929…)
In late 2005, the housing bubble burst, and housing began to decline in price. People who refinanced, particularly those who financed with variable interest rates, suddenly found their homes were valued at much less. The housing market became flooded with homes for sale, because the homeowners with variable rates and interest only loans could not continue to make their payments. Greenspan: The rise in the number of homes for sale caused further lowering of home values. Keep in mind that the main reason for the mortgage crisis is the high number of defaulted home loans, which triggered foreclosures and sell-offs.
worried about a potential loss arising out of a change in the asset price in the future. Hedgers
When a Fortune magazine article highlighted a mysterious investment that exceeded every mutual fund on the market by double digits over the past year and even higher double digits throughout the past five years, the hedge fund business was created. There were just about 140 hedge funds in effect by 1968. In a surprising turn, many funds were withdrawn from Jones’ strategy and chose to charter in riskier gimmick backed on long-term leverage instead of focusing on stock picking coupled with hedging. These strategies led to cumbersome losses in 1969-1970 and between 1973-197...
The participants in the derivatives markets are generally classified as hedgers and speculators. The hedgers use derivatives as main purpose to protect against adverse changes while speculators enter a derivative contract with attempt to profit from anticipated changes in market prices. One of the biggest questions in regard to the treatment of derivatives tools is whether actually they are used for hedging or speculation. (Adam and Fernando 2006)
The presence of relatively low cost alternatives to buying stocks has eased the number of risks, although the major ones still occur (Russell 2009). With the underlying price asset, derivatives can earn investors massive amounts, or returns with small movements. The scenario can change if the underlying asset price moves significantly. The rise in the price of assets will lead to high losses.... ... middle of paper ...
...ting in hedging activities in the financial futures market companies are able to reduce the future risk of rising interest rates. By participating in the financial futures market companies are able to trade financial instruments now for a future date (Block & Hirt, 2005).
‘A derivative is a financial instrument which is a contract between two parties that derives its price from an underlying asset’. Usually, the worth of the principal asset changes continuously as time goes by. These underlying assets could be bonds, stocks or even interest rates. Derivatives are used for hedging and mitigating risks that arise from foreign exchange and commodity dealings. They assure buyers of protection whether or not the type of derivative’s value increases or decreases during the time as specified in the contract (Dubai Islamic Bank, 2013) . All these benefits portray the purchase of a derivative as a good and before the establishment of derivatives, a substantial amount of people and organizations incurred financial losses due to the transaction of unsupervised assets such as money. UAE started introducing derivatives to the nation with gold and silver futures, then currency and after oil futures which are no longer traded in the financial markets. the current ones used in the UAE exist in the from of energy, metals, equities, future contracts and currency.
A derivative is a security with a price that is dependent upon or derived from one or more underlying assets. The derivative itself is a contract between two or more parties based upon the asset or assets. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Derivative products like futures and options are important instruments of price discovery, portfolio diversification and risk hedging. The current scenario shows that the volatility spillover between spot