Ebele Kemery - Rights and Wrongs of Derivatives

Financial landscape has changed dramatically over the previous two decades. Many new financial instruments in form of options, futures and other derivatives are in the market today. Many new financial innovations like off-balance sheet financing, mortgage-backed securities are there. These new financial innovations are massively used for investment and risk management purposes by various financial and other corporations. The instruments are complex to carry out but offer flexibility in making new investments and facing any risk. However as seen in the financial crisis of 2007 such financial innovations could be dangerous and harmful to the very safety of the financial system for which they got invented. The weapons of safety and investments became weapons of mass financial destruction.
 
Derivatives are instruments whose values depend on the underlying asset value. They are complex financial instruments. Derivative like a call option on the underlying stock gives the holder of call option the right to exercise the right to buy the stock at a preset level called the strike price. Mortgage backed securities are the securities offered by the financial institution to the investors with the collateral is the loans issued to the borrowers. The payment on these securities depends on the payments of the loans taken by borrowers. Thus in a way the financial institutes were able to offload the risk of the loans to the investors in the form of mortgage-backed securities. Hence there was no risk for the banks even if the mortgages went into default. So a moral hazard problem was there on part of the banks that went unchecked in the recent crisis. It was the investor of these securities who were bearing the default and other risks. Banks already had cash with them from selling of the loans to the special purpose vehicle. This vehicle then issued the securities backed by these mortgages.
 
The above scenario described created the conditions for the banks to grant loans on less secure basis on the back of growing real estate prices. Banks offered loans to the sub-prime borrowers at low credit guarantees. So when these sub-prime borrowers defaulted resulted in the defaults on the mortgage-backed securities and since these securities were similar in nature the panic got spread to the securities backed by other high quality borrowers. The default on the mortgages led to the panic among the investors so the demand for the mortgage-backed securities decreased and there were heavy losses to the banks which holder these securities on a large-scale. There was a ripple effect of this crisis that soon spread to the other parts of the economy. The crisis soon engulfed the entire financial markets around the world.
 
If one views the above scenario with condition that no such securities exist and there is no off-balance sheet finance exercised by the bank then the bank would have taken the steps to avoid the bad credit loans. Since the profits of the banks and its credibility depends on identifying good quality borrowers and granting loans to only quality borrowers. With the use of creative mortgage-backed securities there was less effort on the part of the banks to control credit creation. This created problems for the entire world. With introduction of this new financial scheme of off-balance sheet financing gave rise to the one of the biggest financial disaster of all times. So this new derivatives and financial innovations have brought about a risk of mass financial disasters.
 
Ebele Kemery says that Hedge funds could use these derivatives for making enormous profits using leverage. The long-term capital management fund established by eminent academics went full burst when its large derivatives place went in to heavy losses after the Russian debt crisis of 1998. The use of leveraged derivatives positions magnifies the returns into large proportions with use of derivatives. So when crisis happened the fund suffered billions of dollars of losses. The same thing happened in recent housing bubble when large investment banks suffered heavy losses and resulting bankruptcy.
 
If there are negatives attributed to derivatives then the positive side is that they have extensive uses by various corporations and financial institutes in risk management. The use of hedging with the help of futures, forwards and options is extensively used for managing risks. For example interest rate risks are kept in control with the help of interest rate futures or interest rate options, volatility of foreign currency is kept under control with currency futures and options, and the commodity prices are kept under control using commodity futures and many other techniques. Banks can mitigate the asset liability mismatch with the help of matching the durations on the asset and the liability side through buying of futures and other derivative contracts. Exotic options derive value from values of various entities and have unique method of valuations. Combination of these options could be use to hedge various risks management. So in a way the derivatives are very important for the risk management.
 
Are we ready to face such disasters that could arise from the use of such derivatives? How much control and regulation is necessary in the use of such instruments. What precautionary steps can various financial institutions take in their designs so that they meet the needs of the investors efficiently? If these instruments have positive side to them then negative side as well. Negative side presented itself to us in the form of the financial disaster of 2007 and positive side is that when used in an efficient and controlled way then they can prove fruitful and useful for the investors. However if their use goes uncontrolled without any precautions to avoid disaster then they can take form of a lethal of weapon of mass financial destruction. If used wisely and judiciously they can offer ideal return after taking into consideration the various risks involved.
 
It is valuable that the use of derivatives has offered financial flexibility and more choice to investors in terms of facing risks and investments. Their use is so vital and important in today's complex financial world that risk management is not possible without them. They are crucial to face adverse economic conditions and adequately offset the downside arising. However one thing is important that there is regulation and controls in their use to avoid disasters on larger scale.
 
Ms. Ebele Kemery is associated with JPMorgan Asset Management. Ebele is a Commodities Leader with a track record of consistently profitable trading efforts. Expanded business through understanding of client needs and developing customized solutions that leverage a wide variety of techniques and market intricacies
To know more please visit: https://sites.google.com/site/ebelekemeryny/