Derivatives Essay

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...

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... 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.