Derivatives and financial crisis Free Essay Example, 2000 words

They started hedging; it is like insuring their financial position against any exogenous condition like, liquidity, foreign exchange, stock market, etc. Derivatives evolved as financial instruments to hedge risks. Hedgers leverage the price volatility of such underlying assets by taking inverse positions contrary to the prevailing market conditions. There are primarily four types of derivatives available in the market i. e. forwards contract, futures, options and swaps. Options and futures are the most common of the lot, though swaps are gaining popularity in the market, owing to the exchange rate volatility (Whaley, 2007). All the above instruments are subject to default risk i. e. counter party failure. As in options, it creates an obligation and not actual right to buy/sell the option, thus prone to default risk where the party may not exercise the option. Under such circumstance the party only pays the option charge, thus reducing his loss burden if he would have exercised the o ption. For example, A purchases an IBM call option for â‚ ¬3 at a strike price of â‚ ¬200 with a one month window. Now A has got either option to exercise the call option. We will write a custom essay sample on Derivatives and financial crisis or any topic specifically for you Only $17.96 $11.86/pageorder now If the IBM stock price rises to â‚ ¬210 within the one month window, A will exercise his option, as the market price of the stock exceeds the strike price and the option charge of â‚ ¬203. In this process, A makes a profit of â‚ ¬7. Though derivatives are used to hedge risks, but can also be used to speculate as seen in the above case. Derivates usually protect investors from market volatility and aims to reduce the risk burden when faced with such volatility (Kolb and Overdahl, 2009). Conclusion With the emergence of newer financial products, risks have also risen, becoming a major area of concern for financial managers around the world. Investors aim to get a high return with minimum risk. They want to be in the top quadrant of the risk-return matrix. Risk is an inherent factor in business. Business’ have developed over the years and have acquired a global status, thus increasing their risk exposure. It is highly imperative for business’ to reduce such risks. In order to reduce the impact of external and market related factors, investors and managers use financial instruments like derivatives to the counter the effect of risk. It is often seen that such investment avenues give rise to speculative practises, thus adding to the pre existing volatility. It has now become a mandate for companies to disclose their derivatives position.