Term Project: A Financial Derivative

Name Instructor Course Date Term Project A financial derivative is a financial asset (contract) whose changes in value or price are derived from changes in an underlying asset, rate, and index (Schoen 810). Derivatives are generally settled at a future date and there are different types of derivatives such as swaps, futures and forwards, and options. The problems linked to derivatives were mostly associated with increased contagion of the systemic risk when there is breach of the counterparty, complexity of the securities and lack of transparency in some markets Derivative instruments help to minimize losses through hedging risks, but they also add volatility to the market. The price movements fueled by speculation can lead to speculative bubbles, which increase the intrinsic value of an asset above its normal market price as was the case with the speculative bubbles bursting in 2008 and affecting the US housing market in the 2007-2009 financial crisis. Derivatives are useful to hedge business risk and speculate in the prices or interest rate. From 2000 to 2008 there was tremendous growth in over-the-counter (OTC) and so did the risk in the financial system. Financial institutions preferred derivatives since they hedged against risk and lowered the value at risk, and the banks were required to hold less capital when they had derivatives. Both banks and investment bank could increase leverage if they held the OTC derivatives, with trades including the same profits or losses as someone owning the securities. One of the reasons why there were increased risks that the derivatives were complicated and not fully understood. The mortgage-backed securities burst and increased contagion to other leveraged bets, and since the losses were huge the big financial players were n financial distress as they had bet big on the derivatives instruments and mortgage lending. More than 90% of the OTC derivatives in the US were held by five big banking institutions at the time of the crisis, and they were unable to hedge business risks during the crisis because of their huge holdings of risky securities (Schoen 809). Financial derivatives increased the volume of lending, but because of their complexity derivative transactions required more innovations. These transactions were then exposed to different risks such as credit risks, legal risks, market risks and operational risks, The securitization and deregulation of credit, as well as the use derivative financial instrument may have increased speculation and risk. Synthetic CDOs are some of the derivatives that were complex and had high risks and when they burst they affected the real estate and mortgage market increased credit consumption combined with the low interest rates, resulted in increased activities in the real estate market at time when the mortgage backed securities and subprime mortgages had become popular. The real estate market was the main source of speculation and credit was advanced to people with poor credit. Schoen ( 806) pointed out that there was excessive risk in the shadow banking and over-the-counter derivatives markets., but the public did not know about this and the risk management practices among the financial industry insiders was poor. The derivatives that were based mortgages on and banks were incentivized to increase mortgage lading to increase profitability. Shadow banking are the activities carried out by the "financial intermediaries that conduct maturity, credit, and liquidity transformation without explicit access to central bank liquidity or public sector credit guarantees '' (Bradley 272). There have bane more efforts to enhance transparency and limit the transmissions of risk after the financial crisis focusing on more standardized derivatives unlike before, where the financial intermediaries were not transparent in their financial dealings. The severity of the US mortgage crisis was linked to the financial system and mechanisms of integration and securitization of credit, rather than just the size of the US mortgage market and the magnitude of subprime loans and low credit rating. The derivative instruments were partly responsible for the transmission of systemic risk in the US financia...