Are the Risks of Derivatives Manageable Essay Example | Topics and Well Written Essays - 1250 words

Are the Risks of Derivatives Manageable - Essay Example The ideas of Thomas A. Bass, who considers that the risks of derivatives are manageable are compared and evaluated with the ideas presented by Justin Welby who argues that the risks of derivatives are not manageable. As per the idea presented by Justin Welby, it can be said that if proper policies and procedures are implemented and maintained derivatives can be used as an effective way to cater and manage a lot of financial risks. However, strong controls are required so as to protect speculation and heavy losses to corporations because of the wrong or unethical use of these heavy duty financial instruments. Are the Risks of Derivatives Manageable? Derivatives and Risks of Derivatives Derivatives are financial instruments or contracts that are settled on occurrence or non occurrence of an event. As explained by Hu in his paper derivatives are the contracts that ‘allow or obligate’ the user / drawer of the agreement to buy or sell the underlying asset at any time in future at the specified cost / price. Hu also explained in his paper that changes in the value of the assets also changes the value of the said contract. This underlying asset can be interest rates, exchange rates, stocks, commodity, goods, etc. (Hu, 1993). Derivatives are either traded in derivative markets or can be directly made or created through any Financial Institution (including banks). Derivatives are widely used these days by corporate entities and other users in order to manage and control the risks associated with financial transactions and hedge the risks of changes in rates of commodities, interest rates, market conditions or foreign currency rates. Hu in his paper also points out the reasons to opt for the derivatives which are: 1. The costs of entering into derivatives contracts (also known as the transactional costs) are much less than buying the underlying assets; (Hu, 1993) 2. Further the risks of change in the price differential between the derivative and underlying assets can be arbitraged; and (Hu, 1993) 3. Derivatives help the users to ‘transfer the market risks’. (Hu, 1993) Derivatives can be in many forms and types ‘including futures, options, swaps, forwards, structured debt obligations and deposits, etc’ (Comptroller of the currency administrator of national banks website, 1997). These financial instruments pose many risks on the users and both the parties involved (that is the drawer and the drawee of the derivative contracts) which include the following risks as presented in the Comptrollers Handbook: 1. Risk of change in the price of investment portfolios, commodities or underlying assets / commodities; (Comptrol ler of the currency administrator of national banks website, 1997) 2. Risk of change in interest rates that may lead to increase or decrease in the prices of investment and earnings; (Comptroller of the currency administrator of national banks website, 1997) 3. Risk of changes in foreign exchange rates specially in case of currency derivatives or where more than one currency is involved; (Comptroller of the currency administrator of national banks website, 1997) 4. Risk of changes in equity or commodity prices in case of equity derivatives lead to risks on the prices and returns on derivatives; (Comptroller of the currency administrator of national banks website, 1997) 5. Risk of Liquidity or credit risks, which means the inability to discharge derivative obligations; (Comptroller of the currency administrator of national banks website, 1997) 6. Transactional risks that means the inability of the parties involved to carry out the derivatives transactions in an effective and efficien t manner. (Comptroller of t