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The Dangers of Derivatives
Introduction
In this essay we will address the proposition made by Warren Buffett (The Oracle of Omaha) that ‘Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.’ We will address this from a microeconomic and macroeconomic perspective assessing the dangers derivatives pose to both and discussing possible changes to reduce some of these dangers.
It is our assessment that if derivative securities are used for the purposes that they were created and if management develops a satisfactory system of internal control to restrain trader behaviour, then from the firm’s perspective derivatives should not become financial weapons of mass destruction. From the macro perspective it will be seen that if regulation of derivatives markets is increased, possible occurrences of macroeconomic mass destruction can be avoided.
Microeconomic Perspective
The microeconomic dangers of derivatives can be decomposed into those relating to the behaviour of traders, the company’s system of internal control and those dangers related to the nature of the derivative securities themselves. ...
Dangers from Trader Behaviour and Lack of Internal Control
‘Risk management is an integral part of running a successful business and investors have the right to expect companies that use derivatives to state their risk-management policies clearly and stick to them,’ (Thomas, T. ...
A danger that derivatives present for financial and non-financial companies is that risk limits are not defined. ...
An example of the dangers that derivatives present without defined risk limits is illustrated by Barings Bank. ...
Another danger of derivatives that affects individual firms is the overconfidence of derivative traders. ... The county’s investment strategy was to borrow short and lend long (Orange County and Derivative Securities, 1997)
A danger of derivatives is that the activities of high performing traders are not monitored closely enough. ...
Another common danger associated with the trading of derivatives is that responsibility relating to the front, middle and back office is often not segregated in accordance with proper internal control procedures. ...
The collapse of Barings Bank is a good example of a lack of segregation in derivatives trading. ...
Nature of Derivatives
The nature of derivatives is that they are complex and computer models are often used in calculating their value. ...
A danger of derivatives for financial firms is that they may be tempted to sell corporate clients inappropriate products, resulting in loss of business reputation. ... said it settled a derivatives-related dispute with a chemical company for $67 million, the largest sum the bank has paid so far to a disgruntled derivatives client. ... com/glossary/restrict/Derivatives-BankersTrust. ...
A further danger to financial firms is the liquidity risk posed by trading certain derivatives. ...
The Chairman of the Board of Governors of the Federal Reserve System Alan Greenspan has said on the topic of risk concentration ‘One development that gives me and others some pause is the decline in the number of major derivatives dealers and its potential implications for market liquidity and for concentration of counterparty credit risk,’ (http://pf. ... On the same topic Warren Buffett stated ‘Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one another,’ (http://pf. ...
Macroeconomic perspective
In order to view the impact of derivatives from the macroeconomic perspective, we will be analysing the Asian financial crisis of the late 1990s. Although many factors contributed to the Asian financial crisis, derivatives played a very large role. ...
The purpose of the use of derivatives in the Asian economy was to manage the risks of global investment. ... Derivatives not only redistributed risk from those who did not want it to those willing to take extra risk, but also created new risks. Thus, derivatives simultaneously allowed capital to flow to developing economies while setting up the foundations of the crisis.
Derivatives allow risk from such securities as bank loans, bonds and direct foreign investment to be reallocated. ... Derivatives also allowed financial entities to increase their risk-capital ratios and therefore dodge regulatory safeguards and also manipulate accounting rules and avoid taxation, (Liu, 2002). ... The use of derivatives thus increases the risk of systematic failure (Plott, 2003).
With derivatives, nothing is owned but price exposure. As derivatives are priced from an underlying commodity they can be used as a means of leverage. One of the most useful properties of derivatives is that they can alter a company’s balance sheet. ... According to the 1998 Central Bank Survey of Foreign Exchange and Derivatives Market Activity, the volume of foreign currency swaps and foreign exchange options traded per day is estimated to be $1.
Approximate Word count = 3792
Approximate Pages = 15.2
(250 words per page double spaced)
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