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

b) the use and misuse of credit default swaps

Answer 1

What is Derivatives?

Derivatives is something, which derive its value from an underlying asset. The asset can be any asset like gold, foreign exchange, tradable/non-tradable securities, bonds, etc.

History of Derivatives:

Derivatives were developed in 1970s, becuase of increase in the volatality of financial markets. This increased valatality led to increase in demand for hedging instruments that were used by financial institutions to manage risks.

How Derivatives can be used for risk management?

Derivatives can be used to hedge an existing market exposure, to obtain downside protection & to protect & retain upside potential.

It can also be used as an insurance against events like defaults.

The most popular derivatives instruments used for hedging are-

1. Futures &

2. Options

Futures: Futures are contracts that are binded to both the parties. These are private contracts that are enetered into between two parties having opposite views about the market. Futures have a maturity date & cannot be exercised before that date. Margins are to be maintained by the buyer of the Future Contract till it matures.

Options: Options in contrast to Futures are developed to enjoy the privilages of a Future Contract but also to overcome the limitations that were the part of Future Contracts. Options as a contract are binded only to the seller & not to the buyer. Unlike, Future Contracts, the buyer may or may not exercise his right to buy the underlying security at the agreed price, but the seller has the obligations to perform his part if the buyer exercise his option. No margins are to be maintained for the Options, instead the consideration for entering into such contract is called 'premium'. In case if the buyer do not exercise his right, the seller may forfiet the amount received from him as "premium". Thus, Options gives right to the buyer, but not the obligation to perform his part of contract, whereas, the seller is obliged to perform his part of contract in case if the buyer exercise his right. Options also have some form which can gives the buyer to exercise his right even before the maturity date.

Credit Default Swaps (CDS):

Credit Default Swaps is a contract that guarantee against the bond default.

Uses of CDS:

CDS are used like an insurance by the buyers/investors of bonds to protect themselves in case the issuer of the bond defaults.

CDS asssures them that the seller of the CDS will make their losses good.

This helps investors to invest in relatively riskier securities which otherwise wouldn't be possible in the absence of CDS.

Misuses of CDS:

CDS are private contracts & so are unregulated, which makes them relatively riskier.

The issuer of the CDS might also default & provides only a sense of security to the buyer.

The buyer might buy more & more riskier securities & secure them through CDS.

This can be disastorous & may even lead to Financial Crisis.