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In: Finance

Q2 2016: The use of derivatives by banks for hedging, trading and speculation has been the...

Q2 2016:

The use of derivatives by banks for hedging, trading and speculation has been
the subject of great debate by regulators, customers and other stakeholders.
Critically evaluate a bank’s use of financial derivatives and the benefits and risks
this generates for both the bank and other stakeholders in the wider financial
system.

Solutions

Expert Solution

The major function of a bank is to take deposit money from the people and then lend the same to users of funds for the purpose of business etc. However, there are periods in an economy where the interest rate is very low and thus banks are not able to generate enough profits for themselves. In order to remain competitive and earn profits, banks do indulge themselves in buying and selling of derivatives directly in the market. They also act as a intermediary in the OTC or over the counter market. In this market they matches buyers and sellers which earns them necessary commission. The bank's operations in its very nature are quite risky, some of the risk involved includes risk of bad debt, NPA, high level of expenses etc.in such cases, the bank will have to hedge themselves against such risks. For example, a bank may purchase interest rate future to protect itself from the losses due to change in interest rates.

Some of the benefits of such use of derivatives for bank is that they can generate good profits and does not completely have to rely on earnings of its operations, the derivatives can be bought and sold also for the purpose of hedging against various kinds of market risks. However extensive use of such derivatives can lead to losses which can erode the regulatory capital of the bank and thus may lead to bank run or bankruptcy. This is perhaps the most important risk that a bank face while getting involved in derivative transactions. Failure of bank is a blow for other stakeholders of the economy as well, like happened in 2008, which triggered a global crisis due to a failure of major banks. Therefore, involvement in derivative transactions comes with both benefits and risks to both banks and other stakeholders in the longer run.


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