1

Financial Derivatives

Name

Course

Instructor

Institution

Date
 2

Introduction

Fixed income derivatives are defined as instruments that have a value that is based on a certain

underlying asset. These instruments benefit the portfolio of an investor by minimizing the costs

and by improving the efficiency of trading. There are certain derivatives instruments that may

help one in maximizing the gains and in minimization of the losses of investments made. In the

recent past, investing has become more complicated with the creation of many derivative

instruments that offer a new way of managing money. Kuppuswamy and Villalonga (2015,

p.905) argues that derivative instruments have been in use for generations especially in the

farming sector where a party to a contract accepts to sell livestock or agricultural goods to a

counterparty who will buy livestock or agricultural goods at a certain price in a certain date. This

contractual agreement has been revolutionary since it was introduced and has consequently

replaced the simple way of exchanging goods. In this regard, this paper examines the concept of

financial derivatives, various types of financial derivatives, the risks involved and how they

contributed to Global Financial Crisis. More so, the paper evaluates various ways of managing

risks associated with financial derivatives.

Fixed income derivative instruments

The simplest derivative instrument allows investors to buy and sell an option on a security. The

investor, however, does not own the underlying asset. Arguably, the investor is able to make a

bet on the price movement through an agreement with the exchange or the counterparty. Ideally,

there are many derivatives instruments that include options, futures, forward contracts and swaps

Kuppuswamy and Villalonga (2015, p.905) points out that derivatives instruments have many

uses and incur many risks levels. They further argue that derivatives are considered per se to be

a better way of participating in the financial markets. Poignantly, the general public fails to
 3

understand derivative instruments and how they are used in hedging of risks since they have a

certain unique language. Each derivative instrument has an underlying asset which would dictate

the pricing, basic structure, and risk. It is imperative to note that the perceived risk of an

underlying asset influences the perceived derivative instrument.

The pricing process of the of the derivative may include the strike price which may be exercised.

More so, there may be a call price with regard to fixed income derivatives that signifies the price

at which an issuer may convert the security. Investors typically use the derivative instruments for

three reasons that include speculation on the movement of the asset, to increase the leverage and

to hedge a position (Kuppuswamy and Villalonga, 2015, p.905). An instance here is that a stock

owner buys a put option so as to protect the portfolio against any decline. As such, the holder

makes money when the stock rises but also may lose or gain if the stock falls since put option

pays off.

Derivatives instruments are able to increase leverage. Leveraging for options works best in

volatile markets when an underlying asset’s price moves significantly and in a favorable

direction because options tend to magnify the movement in price. It has been pointed out that

many investors focus on Chicago Board Options Exchange Volatility (VIX) so as to measure the

potential leverage since it predicts volatility of the S&P 500 Index Options. Investors are also

able to use derivatives to speculate on the future of the asset (Saunders and Allen, 2010, p.67).

Large speculative plays may be executed cheaply since options offer investors the ability to

make leverage on their positions at the fraction of the cost of the underlying asset.

Derivatives may be bought or be sold in two ways which include an exchange and through over-

the-counter. Over the counter derivates are those contracts that are made between parties

privately such as the swap agreements in the unregulated venue (Saunders and Allen, 2010,
 4

p.67). Those derivatives that are traded on an exchange platform are a standardized contract.

Investors point out that there is always a counter-risk when trading through the counter since

contracts are usually unregulated while exchange derivatives are not subject to any risk due to

the fact that clearing house act as intermediaries.

Types of Financial Derivatives Instruments

There three types of derivative instruments that include swaps, futures or forward contracts and

options. Each derivative instrument has different characteristics. Options give right but give no

obligations to sell or buy the asset. Investors tend to use options whenever the have no intention

of taking a position in an underlying asset but still want to maximize exposure when there are

large movements in the price (Saunders and Allen, 2010, p.67). The major types of options

available for the purchase are put and call options. The holder of the call option has a right to buy

the asset while the holder of the put option has a right to sell the asset. Options may offer

protection from swings in prices by enabling the investors to speculate or guess the movement in

prices. The ability of an investor to speculate the right price movements within a certain window

of time may make an investor realize greater benefits and minimize the losses in the investments.

The second category of the derivative instruments is the futures. Future contracts are often used

to promise the delivery at a certain future date which is known as settlement date of the financial

commodity or financial instrument at a certain price. The contract may also be settled in cash.

When trading is done on the future exchange the value may change from day to day and the

investor may close the contract even before settlement date (Financial Crisis Inquiry

Commission, 2011, p. 4). As compared to options, futures, the buyer and the seller of the future

contract must carry out a transaction. When an investor anticipates an increase in price, there is

the likelihood that the investor will buy so as to profit from the increase in the price. On the
 5

contrary, when an investor anticipates a decrease in price in the future prices, there is the

likelihood that the investor will go short or sell so as to profit from an anticipated decrease in

price.,

A forward contract is similar to the future as they require future delivery of the instrument or

commodity or cash settlement to the contract. The objective of this derivative is to profit from

price changes. Forward contracts are however not traded in a regulated or established exchange.

Forward contracts trade over the counter and are regarded as private agreements with better

terms (Saunders and Allen, 2010, p.67). Nevertheless, the private nature of forwarding contract

makes it more susceptible to default by the parties in a contract. The forward contract often has a

settlement date and the delivery of the cash settlement or the asset of the contract takes place.

Swaps are kind of derivatives where the counterparties exchange the cash flows or variables that

are associated with various investments. Many times, a swap happens since one party has a

comparative advantage such as borrowing funds under variable interest rates while the other

party is able to borrow at a more fixed rates date (Financial Crisis Inquiry Commission, 2011, p.

4). There are several types of swaps that include interest rate swaps where parties exchange a

fixed rate loan for a floating rate loan. If one of the parties, has a fixed rate loan but has floating

rate liabilities, it is possible to enter into a swap with another party and exchange the fixed rate

for the floating rate so as to match the liabilities. The other type of swap is the currency swap

where one party exchanges the loan payments and the principal in one currency for the principal

and payments in another currency.

Risks associated with financial derivatives and how they are measured

Derivatives instruments are regarded as very risk financial instruments. The market has been

divided into two major fronts when it comes to risks that are involved in the derivative contract
 6

(Hillier, Grinblatt, and Titman, 2011, p.8). Some investors are of the opinion that given the fact

that financial derivatives are not new securities they cannot introduce any risk in the market. The

proponents of this market agree that derivatives often introduce risks to the market. They concur

that financial derivatives are able to concentrate the risks in a way that the financial system may

not be able to respond in an easy way. In essence, derivatives create a wide number of risks.

Risk Identification for Large Exposures (RIFLE) is one way of measuring risk associated with

derivatives. This measurement methodology compliments value at risk methodology. It is

focused on large potential losses that could occur due to risks such as counterparty risk. Counter-

party risk is one of the risks associated with the financial derivatives. Most of the derivatives are

often traded over the counter. As such, there is no any exchange involved and there is the

probability that the counterparty may fail to fulfill its obligations (Hillier, Grinblatt, and Titman,

2011, p.8). This gives rise to a risk that is associated with the derivative market which is

basically the counterparty risk. Counterparty risk may also be measured in terms of legal risk,

settlement risk or default risk. Essentially, when one party has entered into an agreement with

another party there is the likelihood that one of the parties may not be committed fully to the

agreement. The party may also default on the contract which gives rise to counterparty risk. This

risk may be managed through well-drafted contract agreements which bide each party to tits

obligations.

The other way of measuring risks for derivatives is through value at risk (VAR) methodology

which measures the likelihood that certain future portfolio losses will remain within certain

ranges. The type of risk to measure with regard to derivatives is the price risk. Derivatives that

are traded on the securities exchange are a new phenomenon. Most of the investors including
 7

those who are versed with the trading of the derivatives tend to be clueless as to what must be the

pricing of those derivatives. Roe (2010, p.539) underscores the fact that the functioning of the

market is in terms of a superior knowledge relative to the peers. By applying VAR, an investor is

able to estimate the range of portfolio loss but not the maximum loss. Therefore, there is always

the risk that many of the markets may experience mispricing of the derivatives which may cause

a large-scale default. This happened in one infamous incident that included the company Long-

Term Capital Management (LTCM). The company became a trillion-dollar default and became

an example of how smart management ends up making wrong guesses with regard to the price of

the derivatives. This risk has been managed previously through right speculation and accurate

study of the historical patterns on the movements of the prices.

The other measure of risk is through volatility approach. This is the most traditional measure of

risk. This measure is effective for systemic risk. Systemic risk involves the likelihood of a

widespread default in the financial markets due to the fact that a default initially started in the

market was not controlled and spilled over to a larger derivative market. Since derivatives are

very volatile one default may spin out of the control and entre in the financial market (Roe, 2010,

p.539). The cascading defaults can be controlled by having a control system in the early stages of

derivatives. Systemic risk has been discussed widely in the financial literature. It is, however,

less understood and never quantified. Systemic risk.

In 2008 Global Crisis, the financial markets all over the world came to their knees largely as a

result of systemic. Systemic risk tends to affect the major business of the financial institutions.

This type of risk is not only faced by a particular party but also faced by the entire system. The

solution to this problem can only arrive if there are prudent regulations (Roe, 2010, p.539).

Across the world, regulators are spending their time working on a plan that will help evade or
 8

reduce this type of risk. Therefore, to deal with derivatives will largely depend on how to

manage risks involved thereof effectively. The market is not secure when these high leveraged

investments are involved. As such, much vigilance is required when it comes to trading with the

derivatives.

Another approach is the comfort approach in which require an investor to understand the likely

risks in the market. It is good measure of agency risk. Agency risk arises when an agent fails to

act in the best interest of the principal because their objectives are different from those of the

principal. In this context, it means that if the derivative trader is acting on behalf of the

multinational bank, the interest of the agent and that of the multinational bank may fail to rhyme.

Proctor & Gamble and Barings Bank are financial institutions that have experienced this kind of

risk. Baring Bank had a good public reputation and many people could vouch for. As an age

industrial bank., it ventured into the derivative market (Roe, 2010, p.539). The bank had a

division that would make bets on behalf of the clients. Those traders that were not able to make

successful bets became rewarded greatly. A trader named Nick Leeson was one of the traders

that benefited greatly from this trading of the derivative. Nick Leeson used the money from the

bank and made major bets in the derivative market. He made large profits. Soon, the size of his

ambition became larger and he siphoned more money to the derivative markets. By the time the

management of the Bank noticed of the rogue trading, it had become bankrupt and Nick Leeson

had already fled to Singapore.

Precisely, this example explains that agency risk is a major concern that financial institutions

engaging in the derivative trading must take into consideration. Since derivatives do not appear

in the financial statements of the company, the management of many organizations finds it hard

to track them (Roe, 2010, p.539). Nevertheless, the financial literature on derivative trading
 9

shows that there has been the major improvement on the internal controls since the collapse of

Baring Bank in the wake of rogue trading. Internal controls in most cases are stricter. Any firm

that plans to use an agency in the trading of the derivatives must pay attention and create a plan

that would mitigate such risks.

Financial derivatives and the 2008 Financial Crisis

Derivatives have been compared to antibiotics where without proper management they can be

dangerous to the financial institutions trading with them. Financial Accounting Standard 133 has

been recommended by financiers as the best way of managing the trading of the derivatives.

There is a need to improve on reporting of the risk and value in a world that depends more on the

derivative financial instruments so as to manage risks. Financial scholars point out that financial

derivatives instruments are traded in a fraudulent and unfair manner. Hillier, Grinblatt, and

Titman (2011, p.8) have pointed out that the financial crisis of 2008 was largely attributable to

financial income instruments. Derivative instruments date back to 1970s when they were created

so as to manage risks and create an assurance against a down side. They were basically created

as a result of shock on oil prices and high rates of inflation. More so, these financial instruments

were created as a result of 50% slump in the stock market in U.S. Certain instruments such as

options were invented so as to benefit the upside without the need to own the security and to

protect the downside through payment of small premiums.

During the financial crisis Banks and other financial institutions borrowed so that they could

create more and more securitized financial products. As such, many of these derivative

instruments were created using the borrowed funds or margins so that financial institutions did

not have to give a full capital outlay. The massive leverage amount that was being used during

the financial crisis made the problem worse (Hillier, Grinblatt, and Titman, 2011, p.8). Many of
 10

the capital structures for the banks went from leverage ratios of 15:1 to 30:1. By mid-2008 the

credit market for swaps exceeded the output for the entire market of $50 trillion. As such, any

profit or loss became magnified. In a financial system that had very poor regulations firms

became bankrupt very fast. The AIG group is such a firm which had about $400 billion credit

default swaps in its books. Poignantly, AIG did not have a core capital that would cover these

defaults.

From the financial crisis of 2008, it became apparent that derivatives though work against risks

when used well, when they get complicated so that not even the borrower nor the rating agency

can understand them, the risks become worse (Hillier, Grinblatt, and Titman, 2011, p.8). During

the global financial crisis in 2008, investors such as pension funds got stuck holding some of the

securities that would later turn out to be equally risky. In the same context, banks that held loans

faced similar catastrophe. As financial institutions incurred write-downs it became obvious that

they had few assets as compared to what was required.

Given the effects, the derivative instruments had during the global financial crisis regulators had

to look for ways to prevent such adverse effects in future. Hillier, Grinblatt, and Titman (2011,

p.8). holds that one way of managing negative effects of derivatives in the financial market is

adherence to Financial accounting standards 133 and the international accounting standard 39.

These are said to be the most difficult and complex financial standards that have ever been

written. These standards are very important because they deal with newer types of contracts such

as interest swaps. These accounting standards also deal with those contracts that have been

defined as the primary means by which financial institutions can manage risks and their cash.

These standards were developed by Financial Accounting Standard Board following the trillion-

dollar frauds that occurred in the derivative markets in the 1990s.

 11

The other way to manage risks associated with financial derivatives is through proper audits.

Audits must be conducted by qualified individuals who are independent and who are able to

adhere to the financial standards dealing with the management of derivatives(Flannery, Kwan

and Nimalendran, 2013, p.55). These audits should not be a substitute for the risk control

function. Most importantly, audits should include the appraisal on the adequacy of the

compliance, operations and internal controls. As such, auditors must test compliance with the

policies of the banks and financial institutions. These audits would ensure that risks are arrested

early enough and strong controls are recommended.

The other way is to apply the commitment approach where gross national exposure is calculated.

Also, the global exposure given as net leverage/ gearing arising from portfolio’s derivative

should be calculated. This approach has been developed widely by European Securities and

Markets Authority (ESMA) in the wake of the global recession of 2008 (Flannery, Kwan and

Nimalendran, 2013, p.55). This approach is typically a measure of leverage and fails to reflect

the risk in the market that arises from the derivative. The approach is effective in managing both

the global and national exposure to risk. However, this approach is made more effective when

applied together with the value at risk approach.

The other approach to apply is the value at risk methodology. It is a single metric and provided a

single consolidated view that incorporates the exposure of the scheme to the sensitivities of the

risk. European Securities and Markets Authority, for instance, recommends that investment

strategies must use this approach as a way of complimenting the commitment approach. Value at

risk is able to calculate the expected loss amount that may be exceeded at a certain level of

confidence at a given period of time (Flannery, Kwan and Nimalendran, 2013, p.55). The benefit

of this approach is that it incorporates the interest rates, credit, equity and inflation risk into one
 12

figure. It basically gives a consolidated view in a portfolio and considers both the liabilities and

asserts and can be calculated using both market implied and historical data.

Conclusion

In conclusion, it is important to note that market deregulation, technological developments, and

growth in the global trade have revolutionized the financial marketplace in the past decades.

However, due to increased developments in the financial market, it has become more volatile. In

the end, there has been an insatiable demand for financial products that can manage these risks

hence the evolution of the financial derivatives. Nevertheless, without proper use of these

financial products, the financial crisis is likely to spill off to a larger financial market as seen in

the case of a global financial crisis of 2008. As such, use of financial derivatives requires more

effective regulations and commitment to the accounting standards on the derivatives.

.
 13

References
Flannery, M.J., Kwan, S.H., and Nimalendran, M., 2013. The 2007–2009 financial crisis and

bank opaqueness. Journal of Financial Intermediation, 22(1), pp.55-84.

Financial Crisis Inquiry Commission and the United States. Financial Crisis Inquiry

Commission, 2011. The financial crisis inquiry report, authorized edition: Final report of

the National Commission on the Causes of the Financial and Economic Crisis in the

United States. Public Affairs.

Hillier, D., Grinblatt, M. and Titman, S., 2011. Financial markets and corporate strategy (No.

2nd Eu). McGraw Hill.

Kuppuswamy, V. and Villalonga, B., 2015. Does diversification create value in the presence of

external financing constraints? Evidence from the 2007–2009 financial crisis.

Management Science, 62(4), pp.905-923.

 14

Roe, M.J., 2010. The derivatives market's payment priorities as financial crisis accelerator. Stan.

L. Rev., 63, p.539.

Saunders, A. and Allen, L., 2010. Credit risk management in and out of the financial crisis: new

approaches to value at risk and other paradigms (Vol. 528). John Wiley & Sons.