Derivatives and Financial Crisis - Assignment Example

Derivatives and Financial Crisis Contents Contents 2 Derivative Instruments 3 How it became speculative 3 Main Purposes 4 Conclusion 5 Overview of Recent Financial Crisis (2008) 6 The Housing Sector 6 Benchmark Comparison to the US 7 The Spread of the Subprime crisis 8 Conclusion 9 References 10 Derivative Instruments It is a financial instrument or a security whose price is determined from the underlying asset. The asset price fluctuations influence the price of the derivative. It is resorted by individual and companies to hedge risk and also to speculate. There are usually two types of risks i.e. systematic and unsystematic risk. Derivatives are used to minimise the effect of such risks. Though the negative event cannot be avoided, but the impact can be greatly reduced by hedging through derivatives. They are mainly of four types vis- a-vis futures, forwards contract, options and swaps. Such types of derivatives are used based on the type of risk exposure i.e. liquidity, financial, exchange rate risks, etc (Chisholm, 2011). How it became speculative Derivatives were used primarily to hedge risk, but over time people used it to make gains out of the price movements of the underlying assets. The purpose of using derivatives is incumbent on the investment objective. The price volatility of the underlying influenced various investor community to use derivative as a lucrative investment option. Earlier the use of derivatives was not popular, owing to its complexities it was not considered to be a feasible investment option. Over time, it was adopted by various investors to insure the various risks facing them. With various risk outcomes, the fluctuations in the price of the underlying assets made it volatile. Such price volatility attracted speculators, who engaged in the use of derivatives to earn profits. Speculations are done on both the up trends and down trends of the asset price movements. The impact of speculations is felt across the investor community i.e. the hedgers. Speculators gamble on the direction of the asset price movement. When a speculator feels that the price of the underlying asset will fall, he will short sell the stock or buy an option. When the price of the asset falls, he exercises the option or buys the underlying asset to make profit. Speculators leverage the vulnerability of the price movements of the asset to make gains. Though all types of derivatives cannot be used to speculate, but futures, options and swaps are lucrative avenues for speculators (Poitras, 2002). Main Purposes From the inception, starting in 1970’s and continuing through the ‘80’s and ‘90’s, the financial market evolved and made it a riskier place for trading. The interest rate changes, bonds and stock markets witnessed phases of increased volatility. Owing to such evolution of risk, investors and managers of financial institutions became wary and resorted to derivatives to minimise the impact of such risks. 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 option. For example, A purchases an IBM call option for €3 at a strike price of €200 with a one month window. Now A has got either option to exercise the call option. If the IBM stock price rises to €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 €203. In this process, A makes a profit of €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. This rule was implied to protect the investor community at large, who are at greater risk of losing money. Companies often engage in speculative practises in the derivative market. It increases the default risk exposure beyond the threshold limit, thus affecting various groups of investors in the process. The impact of such events can create havoc on the home economy as well as other economies that are directly or indirectly related to such trading (LiPuma and Lee, 2004). Overview of Recent Financial Crisis (2008) The financial crisis of 2008 is characterised by subprime lending by US banks. The government wanted to fuel growth in the economy and started to slash the interest rate from 6.5% to 1.75%, creating excess liquidity in the economy. This attracted a lot of subprime groups with low income and asset. The US banks started giving mortgage loans to such low credit groups, pushing the economy growth. The government slashed the interest rate further to 1%, creating a credit rush. Such mortgages were converted to security backed mortgages, which were subscribed by major financial institutions and insured by the major insurance companies in the US. Slowly as the interest rate started to rise, the subprime borrowers started to make payment defaults, which resulted in bankruptcy. This situation prevailed for a long time and ended up in failure of major financial institutions like Lehman Brothers, American Insurance Group, Fannie Mae, Freddie Mac and others. The subprime crisis affected various other economies as these big companies had parked their money in emerging markets stock exchange and pulled out to manage liquidity, leaving those economies at peril (Addo, 2010). The Housing Sector The US government wanted to push economic growth, following the mandate the Fed Reserve made interest rate cuts to make homeownership available to a large section of the population at cheap rates. Mortgages were considered to be the next big thing after gold. Subprime borrowers started taking mortgages at low rates. Such borrowers had very poor credit history, low income level and asset value. The Fed’s action was seen as a good gamble, as the home ownership reached a new high of 70% in 2004. The market forces of demand supply adjusted itself, and banks started increasing the interest rates. This resulted in higher interest payments, which were not affordable by the subprime borrowers. Banks started to take possession of the mortgaged homes, leading to a fall in demand of the housing sector by the end of 2005. The US Home Construction Index fell to a new low and stood at 40% in 2006. The Fed’s loose expansionary policies lead to the subprime crisis (Addo, 2010). Benchmark Comparison to the US The Asian financial crisis is discussed in brief to compare with the Subprime crisis of the US. Though the nature of the crisis had some subtle differences, yet both originated from inefficient banking regulation. The Asian crisis was predominantly because of the asset bubble and fixed exchange rate system. The Asian economies opened their economies to foreign capital for building their assets which subsequently created an artificial rise in the price of the assets. Over time the interest rates on such capital investments grew, making it less affordable for the affected economies to compensate for their fixed exchange rates. The subprime crisis was mainly because of subprime lending and asset securitization, whereas the Asian crisis was mainly because of banking intermediary irregularities regarding short term capital inflow. The impact of the two crises was different in magnitude and spread. The subprime crisis had greater impact than the Asian financial crisis. During the subprime crisis, the world economies were financially integrated, unlike during the Asian crisis, leading to a fall in many other economies. The Asian crisis started from two economies, the first phase started from Thailand and spread to Malaysia, and Korea and the second phase started from Philippines and spread to Taiwan and Indonesia. Unlike, the Asian crisis the subprime crisis affected various economies originating from the US. The absolute loss was greater for Subprime crisis and Asian crisis recorded a high loss percentage (Soros, 2008). Country Economic Loss (Absolute difference in US$) Difference in GDP (%) The subprime crisis figures are discounted to 1997 with a discounting rate of 5% p.a. Thailand -68 -40% Indonesia -171 -83% Philippines -28 -37% Malaysia -35 -39% South Korea -147 -34% ASEAN Countries -449 -46% US -5095 -43% Table 1: Comparative schedule of Economic loss and GDP The table is representative of the comparisons of the impact of the Asian financial crisis and the subprime crisis on the respective economies. The ASEAN countries absolute economic loss was $449 billion compared to US, which stood at $5095 billion. US economy suffered a GDP blow of 43% compared to the Asian counterparts’ share of 46% (CIA, 2009). The Spread of the Subprime crisis The subprime mortgages were converted into mortgage backed securities and collateralised mortgage obligations and traded in the secondary market. Such MBS and CDO’s were purchased by various foreign insurance companies, hedge funds and banks to the tune of $1 trillion in 2007 across the globe. The CDO and MBS interest payments were paid from the interest payments received from the subprime mortgages. Incidentally when the subprime borrowers defaulted on their interest payments, owing to the spiralling interest rate in the economy, the underwriting companies like Fannie Mae, Freddie Mac, Ginnie Mae, Wells Fargo and others failed to compensate the Foreign Institutional Investors. Such credit default had a snow balling effect on the FII’s from different economies. Various hedge funds, pension funds, financial institutions, insurance companies were adversely affected by the credit crunch in the US economy. The US economy was most affected, as it witnessed the fall of major bank and insurance companies, leading to a state of financial paralysis. Conclusion Following the subprime crisis, the US government enacted the National Economic Stabilization Act in 2008. The Fed Reserve pushed in more than $700 billion to buy the stressed assets of the bank i.e. MBS and CDO’s. It tried to reduce the funds and discount rate to 1% and 1.75% respectively. Such financial stimulus failed to prevent the bankruptcy of major American companies like Lehman Brothers, American International Group, Indymac bank, Merrill Lynch and others. The financial crisis felt repercussions across the globe. The Fed’s loose policy action resulted in the fall of the US economy. Moreover the banking irregularities and credit rating agencies misleading ratings of the MBS and CDO’s also resulted in the financial tumult that affected various economies and their earnings (Addo, 2010). References Addo, H., A., 2010. The 2008 Financial Crisis: The Death of an Ideology. Pennsylvania: Dorrance Publishing. Chisholm, M., A., 2011. Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options. USA: John Wiley & Sons. CIA, 2009. The World Factbook. [Online] Available at: https://www.cia.gov/redirects/ciaredirect.html. [Accessed on 16 March 2015]. Poitras, G., 2002. Risk Management, Speculation, and Derivative Securities. USA: Academic Press. Kolb, R., and Overdahl, A., J., 2009. Financial Derivatives: Pricing and Risk Management. New Jersey: John Wiley & Sons. LiPuma, E., and Lee, B., 2004. Financial Derivatives and the Globalization of Risk. USA: Duke University Press. Soros, G., 2008. The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means. USA: PublicAffairs. Whaley, E., R., 2007. Derivatives: Markets, Valuation, and Risk Management. New Jersey: John Wiley & Sons. Read More