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Transactions on derivative contracts occur between two parties in which a financial agreement is done whose payments depend on the value of the underlying assets and securities. Derivative contracts are broadly categorized into lock and option products. Lock category derivative contracts bind the two parties into an obligation of executing the contract according to the terms and conditions over the period for which the contract is agreed upon. Option product derivatives are contracts that provide the right to the buyer but not the obligation to execute the contract over the period of the contract (Whaley, 2007, p.121). The derivative contract includes an agreed upon price between the two parties to buy or sell the product within a specified period of time. The derivative contracts may be traded in the exchange in which case these are called exchange-traded-derivatives or may be privately traded in which case these are called Over-the-counter derivatives. Over the counter derivatives are not traded in specialized exchanges. Recent examples of banks and companies making heavy losses from using derivatives The financial meltdown of 2007 in US was largely due to the fall in the mortgage prices which served as underlying assets for loan products. Irresponsible lending, relaxed policies of the banks, corporate houses and happy-go-lucky attitude of the regulators in assessments of the derivative products led to the fall of big banks like Lehmann Brothers. After a meagre financial recovery from the support of the government, derivative market is again one of the biggest markets in today’s global financial scenario (Schwartz and Smith, 1997, p.499). Banks today are carrying out transactions on derivative markets on a much larger scale than ever before. The banks are more opaque and are indifferent to the risky derivative products. Banks, however, are unwilling to disclose the face of the derivative contracts to their investors. It is understood that a change in the underlying market factors would lead to massive losses of the world economy as a result of devaluation of the underlying assets. The size of the derivative markets has grown from $500 trillion in 2007 to $707 trillion in 2011. Lack of transparency in trading of derivative contracts reflect the risk involved as a result of probable fluctuation of underlying market factors. This can be observed in the light of recent examples. J P Morgan has registered a loss of $6 billion due to trading in risky derivatives. The increasing size of derivative markets and declining due diligence in investments in order to achieve higher profits imposes higher risk. Several high ranked officials from big companies like Meryl Lynch, Morgan Stanley, and Citigroup commented that the banking industry is vulnerable in the wake of huge losses in derivative markets. After the earthquake in Japan, J P Morgan decided to reverse their position in derivatives due to the huge losses to be incurred. In 2011, Deutsche Bank decided to reduce the foreign currency exposure of Post bank by €8.1 billion looking at the heavy losses in their investment in derivatives. Deutsche bank themselves lost $1.74 billion in US derivative markets. A huge foreign exchange option for Hewlett Packard was executed early in order to reduce the losses predicted out of market uncertainty. Due to lack of transparency on the investments in derivative ma ...Show more
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Financial services Contents Derivative contracts 3 Recent examples of banks and companies making heavy losses from using derivatives 3 Evaluation of the risks and benefits of derivatives contracts 5 References 8 Derivative contracts Derivative contracts are financial instruments whose value is derived from the value of its underlying assets, security, market index, etc…
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