Role Of Derivatives In The Great Recession Writing Assignment (Essay Sample)

SUBJECT: ROLE OF DERIVATIVES IN THE GREAT RECESSION
STUDENT NAME:
STUDENT NO:
TUTOR:
DATE:
COURSE CODE:
Introduction
A derivative is said to be a contract between two or more parties whose value is based on an underlying agreed variable financial asset (a security) or several assets (like an index). One can say that this product whose value derives from is dependent on the value of an underlying asset for example future or warrant being dependent on commodity or security. Currency is also considered to be an asset commonly the US dollar whereas there are derivatives that are based on bonds or stocks. The Great Recession is described as a prolonged period of severe economic downturn. The economists trace this to the most recent one that brought about the downfall of the United States market in the year 2007. This lasted from December 2007 to June 2009. This led to a drop in asset values due to a fall in stock prices. The main purpose of the paper to analyze the benefits and dangers of financial derivatives. It also seeks to analyze the current economic situation as well as the past events to see if financial derivatives are the cause of a financial crisis.
Role of Derivatives in the Great Recession
The volatility experienced in the bond and stock market in the 1970s went on increasing in the 1980s and 1990s making the financial markets risky as the interest rate swings became broader. This led to the introduction of new financial instruments that were in the form of financial derivatives that helped managers to assess their risks better. They led to the reduction of the risks that most financial institutions faced. For instance, hedging whereby this is engaging in a financial that offsets a risk altogether whether a long position or short position. A financial institution is said to have taken a long position if they buy an asset. A derivative can be traded on organized exchanges or through an over the counter (OTC) market. Similarly, it is said to have taken the short position if it has sold an asset that it had agreed to deliver to another party at some future date. (Mishkin, 2007, p. 333). Derivatives can either help stabilize an economy or ruin it bringing the whole economic system to its knees. Usually, the impulsion experienced is due to the inability to identify the real risks where corporations that are interconnected become bankrupt is as a result of a poor derivative structure with another failed firm. The list below contains both advantages and disadvantages associated with derivatives:
Advantages of derivatives
Increase the value of firms- via hedge market risks. In a market with fluctuating market prices and interest rates, sudden changes are necessary. Derivatives lock in the rates as well as fixed prices to protect businesses from these fluctuations. It acts as insurance against the adverse conditions, also permits the risks to be unbundled from a cash flow, therefore increasing the value of an asset. Thorbecke gives a good example of where a 30-year bond pays the holder a fixed payment twice a year and the principal after 30 years. He points out that this can be broken down into 60 coupons and the principle that can all be sold separately allowing the individual to purchase a duration and risk in a manner that they prefer. Here, the unbundling of the asset into portions increases the value of cash flow greatly and also effectively manages risks.
A derivative instrument can be used by a firm to distribute risks more like transferring risks from risk-averse people to risk-oriented people. Asset prices and interest rates are considered to be essential in a market economy because they offer signaling factors that aid in the use and allocation of resources. Computer-assisted strategies help the investors to easily pinpoint the asset prices as well as interest rates that are not matching with the fundamentals. The purchase of an underpriced asset and short selling an overpriced asset make the asset prices to move in the direction of the fundamental value thus catalyzing the entrepreneurial activity.
Derivatives bring about an increase in savings and investment in the long run. Leading to an increase in the profitability of a banking system. It is well known that banks have been making a profit from the spread between an interest rate received from assets and also from the interest paid on liabilities. With the introduction of financial derivatives, banks have increased their profits by large amounts.
The innovation of derivatives has led to the discovery of future as well as current prices. Future market prices are dependent on a continuous flow of information worldwide and a high degree of transparency is required. The demand for commodities is affected by a broad range of factors such as political situations, climatic conditions, and debt default among others. The price of a contract with the shortest time of expiration serves as a proxy for an underlying asset.
Disadvantages of derivatives
Leverage – it is next to impossible to know the real value of any derivative since it is mostly based on the value of an underlying asset that is most of a greater amount of money than the one invested. An increase in leverage makes an institution to take a large bet on currency and the interest rate movements. It can be catastrophic to an institution if anything goes wrong. Even though the derivatives can be used to counter the risks, they have a big capacity to bring down the whole institution.
Systemic risks – derivative trading expose the economy to systemic risks that cause a domino effect where institutions that are interconnected are affected and affect the whole economy eventually. This failure is considered to be disastrous by causing banking panic where depositors withdraw their funds in large numbers. Therefore this implies that there is a high danger posed due to close linkages between markets because the downfall of a major financial firm in the world will affect other firms worldwide.
Volatility &...