Financial Risk Management (FRM)

Assignment no: 1

Submitted by: Faheem AslamReg #: MM101028

Derivatives as means of mass destruction or source of Market Stability

A: Criticisms:

Financial derivatives are weapons of mass destruction OR provide stability to markets, there is no consensus. There are different views; lets explore the critics of derivatives 1st and than the proponents of financial derivatives.

In my view financial derivatives are just like time bombs, both for the parties that deal in them and the economic system.

Custom-tailored financial derivatives are a neat example of how invention becomes the mother of necessity. They have done so because derivatives create a felt need for their own employment. Derivatives make it possible for businesses from construction to food processing to energy to shipping to make plans with greater certainty about their financing costs than they ever could before.

The dangers of derivative reporting on and off the balance sheet. Mark-to-market accounting is a legal form of accounting for a venture involved in buying and selling securities in accordance with U.S. Internal Revenue Code Section 475.Under mark-to-market accounting, an asset's entire present and future discounted streams of net cash flows are considered a credit on the balance sheet. This accounting method was one of the many things that contributed to the Enron scandal.

Many people attribute the Enron scandal entirely to cooking the books or accounting fraud. In fact, marking to the market or "marking to the myth", also plays an important role in the Enron story. Mark-to-market accounting is not illegal, but it can be dangerous.

Many types of derivatives can generate reported earnings that are frequently disgracefully overstated. This occurs because their future values are based on estimates; this is problematic because it is human nature to be optimistic about future events. In addition, error may also lie in the fact that someone's compensation might be based on those rosy projections, which brings issues of motives and greed into play.

Unfortunately, these "over the counter" derivatives—created, sold and serviced behind closed doors by consenting adults who don't tell anybody what they're doing—are also a major source of the almost unlimited leverage that brought the world financial system to the brink of disaster last fall. These instruments are creations of mathematics, and within its premises mathematics yields certainty. But in real life, as Justice Oliver Wendell Holmes wrote, "certainty generally is an illusion." The derivatives dealers' demands for liquidity far exceed what the markets can provide on difficult days, and may exceed the abilities of the central banks to maintain orderly conditions. The more certain you are, the more risks you ignore; the bigger you are, the harder you will fall.

Basically Derivatives call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices, gold, oil, agricultural products or currency values. For example, if you are either long or short a KSE 100 futures contract, you are a party to very simple derivatives transaction, with your gain or loss derived from movements in the index. Derivatives contracts are of varying duration, running sometimes to 20 or more years, and their value is often tied to several variables.

Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counter-parties to them. But before a contract is settled, the counter-parties record profits and losses – often huge in amount – in their current earnings statements without so much as a penny change hands. Reported earnings on derivatives are often wildly overstated. That’s because today’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed for many years.

The parties to derivatives also have enormous incentives to cheat in accounting for them. Those who trade derivatives are usually paid, in whole or part, on “earnings” calculated by mark-to-market accounting. But often there is no real market, and “mark-to-model” is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counter-parties to use imaginary assumptions. The two parties to the contract might well use differing models allowing both to show substantial profits for many years.

The Bonuses of the CEO are linked with the stated profit, so this marking error is supported by the CEOs for the huge bonuses and to show their good performance. The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.

When a company goes down due to many reasons, many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counter-parties. Imagine then that a company is downgraded because of general misfortune and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.

Derivatives also create a similar risk by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counter-parties tend to build up over time. A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. However under certain circumstances, an exogenous event that causes the receivable from Company A to go bad will also affect those from Companies B through Z.

Many people argue that derivatives reduce systemic problems, in that participants who can’t bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants. On a micro level, what they say is often true.

However, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others.

On top of that, these dealers are owed huge amounts by non-dealer counter-parties. Some of these counter-parties, are linked in ways that could cause them to run into a problem because of a single event Linkage, when it suddenly floats up, can trigger serious systemic problems.

Derivatives caused the Crisis?Why?Let’s do some quick math.If you add up the value of every stock on the planet, the entire market capitalization would be about $36 trillion. If you do the same process for bonds, you’d get a market capitalization of roughly $72 trillion.The notional value of the derivative market is roughly $1.4 QUADRILLION.I realize that number sounds like something out of Looney tunes, so I’ll try to put it into perspective.$1.4 Quadrillion is roughly:-40 TIMES THE WORLD’S STOCK MARKET.-10 TIMES the value of EVERY STOCK & EVERY BOND ON THE PLANET.-23 TIMES WORLD GDP.

The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts. In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now hidden, are potentially dangerous.

B: Support

Financial Derivatives Improve Market Efficiency for the Underlying Asset. For example, investors who want exposure to the KSE 100, he can buy KSE 100 stock

index fund or replicate the fund by buying KSE 100 futures and investing in risk-free bonds. Either of these methods will give them exposure to the index without the expense of purchasing all the underlying assets in the KSE 100.

If the cost of implementing these two strategies is the same, investors will be neutral as to which they choose. If there is a discrepancy between the prices, investors will sell the richer asset and buy the cheaper one until prices reach equilibrium. In this context, derivatives create market efficiency.

Credit derivatives: effects on the stability of financial markets Credit derivatives are becoming increasingly popular, so the obvious question is whether, and how, they affect the stability of financial markets. Generally, credit derivatives improve the overall allocation of risks within financial Systems. They do so in two ways:

• Credit derivatives make risk management more efficient and flexible especially at banks. • Credit derivatives allow a more efficient distribution of individual risks and a related reduction of aggregate risk within an economy.

Credit derivatives are a means of more efficient risk allocation. Credit derivatives have potential to improve the allocation of risks both within an individual economy and at the global level, and to increase the stability of banking and financial markets. At the microlevel, credit derivatives are an additional instrument for transferring credit risks. They have properties that conventional means of risk transfer (e.g. sale of credit, credit insurance, etc.) do not always possess.

Above all they are tradable and can be used for the synthetic composition and dynamic adjustment of a bank’s credit portfolio. Ultimately, credit derivatives help banks to increase or reduce credit risks independently of the underlying transactions, to diversify risk across sectors and countries, and thus to optimize their overall risk profile. With credit derivatives, banks are in a better position to prevent financial difficulties and to alleviate credit problems in specific sectors or regions. The entire banking sector should become more stable as a result.

At the macroeconomic level, the distribution of risk within the economy as a whole improves with the use of credit derivatives. Credit risk connected with conventional bank loans can be borne by sectors for which this was previously impossible. The credit risk – which has been borne primarily by the banks in the past – is distributed more broadly by being passed on to other market participants such as insurance companies, investment trusts or hedge funds. But risks are not only redistributed: aggregate risk

also decreases to the extent that the new protection seller is able – because of a differently structured credit portfolio – to assume the exposure at lower costs than the original lender. This results in a more efficient allocation of risks within the economy. Economic shocks such as a slump in growth or, more especially, crises in specific sectors or companies can be better absorbed as the associated costs are lower in total and less concentrated. The use of credit derivatives can therefore improve the overall stability of the financial system.

The fact that the defaults by Enron, WorldCom and Argentina did not lead to more serious financial difficulties at individual banks or to any chain reactions in the banking sector is considered to be largely due to the use of credit derivatives on these debtors. The markets also digested other large credit events (see table) quite successfully by making use of credit derivatives.

Besides having a stabilizing effect, credit derivatives can supply important additional information on the borrower’s creditworthiness through their pricing – provided the markets are sufficiently liquid. They thus improve the information efficiency of financial markets. In other words, credit derivatives help to make the financial system more efficient and more stable through several channels. However, credit derivatives and their growing use also entail risks. While there s considerable evidence that the benefits of credit derivatives exceed the costs, it is necessary to weigh up the pros and cons carefully to arrive at a definitive judgment.

Derivative markets have been blamed for contributing to the financial crisis. But appropriate policy responses require differentiation across the variety of what actually trades in these markets and attention to the details of how these markets work in practice.

On the other hand, many details of market practice across all derivatives were ex ante causes of concern in the crisis and have not yet been fully addressed. Aggregate derivative exposures of financial entities to one another did not seem readily available either to regulators or to the financial entities themselves. While the net derivative exposures of counterparties to one another might have been reasonable, the gross or notional amounts, which become important in the event of bankruptcy and liquidation, were staggeringly large. Financial relationships and transactions across entities of the same company were extremely complex in ways that did not matter for the conduct of day-to-day business but that mattered a lot in a stressed environment. Finally, unwind or liquidation procedures that had been adequate in processing the failures of relatively small financial institutions were not confidence inspiring during the crisis.

Hedging has traditionally been defined as a strategy for reducing the risk in holding a market position while speculation referred to taking a position in the way the markets will move. Today, hedging and speculation strategies, along with derivatives, are useful tools or techniques that enable companies to more effectively manage risk.

Derivatives Also Help Reduce Market Transaction Costs Because derivatives are a form of insurance or risk management, the cost of trading in them has to be low or investors will not find it economically sound to purchase such "insurance" for their positions.

1. When a derivative fails to help investors achieve their objectives, the derivative itself is blamed for the ensuing losses when, in fact, it's often the investor who did not fully understand how it should be used, its inherent risk, etc.

2. Some view derivatives as a form of legalized gambling enabling users to make bets on the market. However, derivatives offer benefits that extend beyond those of gambling by making markets more efficient, helping to manage risk and helping investors to discover asset prices.

While professional traders and money managers can use derivatives effectively, the odds that a casual investor will be able to generate profits by trading in derivatives are mitigated by the fundamental characteristics of the instrument:

In conclusion of all this discussion I would like to say that derivatives are not the major reason of losses or crises if they are regulated properly and the parties involved in derivatives are vigilant and have knowledge to use these instruments..