Question

Discuss the primary reasons for the initial development of the derivatives market and how such instruments can be used for risk management purposes.

In your discussion, be sure to address:

a) the main differences between hedging with futures and hedging with options and

b) the use and misuse of credit default swaps.

Answer 1

Like other segments of Financial Market, the initial development of the derivatives market is for the following reasons:

.1. Derivative market helps in improving price discovery based on actual valuations and expectations.

2. Derivatives market helps in trasfer of various risks from those who exposed to risk but have low risk appetite to participants with high risk appetite.

Eg. Hedgers want to give away the risk

3. Derivative market helps shift of speculative trades from unorganized market to organized market. Risk management mechanism and surveillance of activities of various participants in organized space provide stability to the financial system.

Risk Management through derivative:

The main participant in derivative market is Hedgers. They face risk associated with the prices of underlying assets and use derivatives to reduce their risk. Corporations, Investing Institutions and banks all use derivative products to hedge or reduce their exposures to market variables such as interest rates, share values, bond prices, currency exchange rates and commodity products.

Hedgers reduce their risk by taking an opposite position in the market to what they are trying to hedge.

The main difference between Future and options is that in case of Future derivative, both buyer and seller has the obligation to buy or sell the contract on a date specified, but in case of option, buyer of the option has the right to execute the transactions, but seller of the option has the obligation to execute the transaction.

a. Differences between hedging with futures and hedging with options:

For example, assume a jewelry company has a contract of gold with one of gold company and the contract is due in six months. The company is worried about the volatility of the gold prices and expect that the price may increase in the future. In order to protect itself from this uncertainty, the jewelry company could buy a six month future contract in gold. If gold price experience a 10% price increase, the future contract will lock in a price that will offset this gain.

In the above example, the jewelry company can also buy a Call option to hedge its position. When the spot price will increase above the strike price of Call option, the company can exercise its right to buy at strike price by paying a small premium.

Use and misue of Credit Default Swap:

Benefits:

1. Measuring market assessment of the borrower's health and their probability of default

2. Allowing greater transparency in the pricing credit throughtout seperation of the cost of funding and credit risk.

3. Increase the Liquidity i.e access to capital

Misuse:

It can be misused or manipulated that can lead to distressing results.

For eg. Party B buys protection from party C for loan made to party A. where C conducts the same behaviour with buyer D, and D buys protection from the insurer E. in this example, there are three individual agreements made, but economically only the last buyer E customer is the only risk holder.