Question

Can you give reasons to use derivatives and was there any role of these in recent financial crisis? Explain with appropriate examples.

Answer 1

a. There are four main types of derivatives Forward, Futures, Swap and Options. They are mainly used for Hedging and speculations.

1. Hedging - Hedgers use derivatives to manage financial risk and thus reduce uncertainty. For example- 6 months back I knew that I need to buy oil today and as per the trend the price of oil is constantly increasing Hence I entered into a forward contract to manage that risk of rising oil prices. and Today the oil price has increased by 10% compared to what it was 6 months back but because I had a forward contract I will be buying oil at a lower price. In this way, derivatives are used for hedging purpose.

2. Speculation - Speculators use derivatives to get profit from it. Suppose X feels that the ABC company stock price will be higher in the next six months than what it is today. X can use options to buy ABC company's stock at today's price and potentially profit from it if the stock price goes up.

b. Role of Derivatives in the Financial Crisis:

In 2008 the derivates market was highly unregulated. We know that the price of derivatives is derived from the price of its underlying asset example - mortgage-backed security. Banks used to sell mortgages to the Federal National Mortgage Association (FNMA) to generate cash for loans. and FNMA sold the mortgages in the secondary market to make money to give to banks. Mortgage-backed Securities (MBS) were traded in the secondary market. when MBS are bought its buyer gets a proportional amount of monthly payments and principal repayments. So when the housing bubble burst happened in the summer of 2007, the whole MBS security market collapsed and since it was not regulated by any institution MBS investors suffered a huge loss during the financial crisis.