Financial Risk Management (FRM)

Assignment no: 1

Submitted by:
Reg #:

Faheem Aslam
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-tomarket 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" derivativescreated, sold and

serviced behind closed doors by consenting adults who don't tell anybody
what they're doingare 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. Thats
because todays 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 cant 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?
Lets 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, youd 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 Ill
try to put it into perspective.
$1.4 Quadrillion is roughly:
-40 TIMES THE WORLDS 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 banks 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 borrowers 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.
.