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Unit 19

Reading 1

Listening

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Defending the use of derivatives

There are many bene ts of derivatives. The clearest one is hedging risk exposure. Since
the value of the derivatives is directly linked to the value of the underlying asset, the
contracts are primarily used for hedging risk. This means that an investor can purchase a
derivative contract whose value moves in the opposite direction to the value of an asset
the investor owns. The risk, therefore, goes down, but of course, so does the reward. A
real-life example is that farmers can protect themselves from the e ect of poor crop
yields. International corporations can use currency swaps to eliminate their
exposure to exchange rate uctuations.

It is also considered to increase e ciency in the nancial markets. By using derivative

contracts, you can replicate the dividend on the assets. Therefore, the bid prices of the
underlying asset and the associated derivative must be in balance to avoid arbitrage
opportunities.

So, in conclusion, the derivative is a tool that can be used when one experiences
that one’s assets risk level goes up more than desirable.
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 Outlining the dangers of derivatives
Derivatives come with many drawbacks. The nancial instrument is one of, if not the,
biggest reasons behind the global nancial crisis in 2008. The rapid devaluation of
mortgage-backed securities and credit-default swaps led to the collapse of nancial
institutions and securities around the world.

Derivatives are widely regarded as a tool of speculation. Rather than using derivatives
to lower risk, it is used to gain higher risk and thus a higher reward. Due to the extremely
risky nature of derivatives and their unpredictable behavior, unreasonable speculation
may lead to huge losses.

There is a counter-party risk. Although derivatives traded on the exchanges generally go

through a thorough due diligence process, some of the contracts traded over-the-counter
do not include a benchmark for due diligence. Thus, there is a possibility of counter-party
default.

One example of how much damage derivatives can cause is the Enron collapse in 2002.
Enron’s extensive use of derivatives lies at the root of the fallen energy giant’s slide into
the largest bankruptcy in US history. Frank Partnoy, a law professor at the University of
San Diego explains: “Speci cally, Enron used derivatives and special purpose vehicles in
three ways. First, it hid speculator losses it su ered on technology stocks. “Second, it hid
huge debts incurred to nance unpro table new businesses, including retail energy
service. Third, it in ated the value of other troubled businesses, including new ventures in
ber-optic bandwidth.” So Enron used its expertise in derivatives to hide these losses.
Which in the end bit them in the back and the bankruptcy was a reality.

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 Balancing both the advantages and disadvantages of derivative use
When used right, derivatives are a practical tool that helps people from taking higher risk
than they can handle. An increased level of risk can be unexpected, thus derivatives in a
way can be the savior. The unpredictability is hedged. Such as in the farmer's example,
where the weather is a huge factor in how crop yields are going to be during a year. The
nancial tool makes the potential fall in revenue softer as well as lowers the
maximum amount of revenue. But in the end, that might be worth it as the worst-case
scenario without derivatives may be to go bankrupt. So, if used properly, derivatives can
be a very helpful nancial management tool. It may even be so that att the economy
could face similar consequences if the derivatives were to be forbidden as the derivatives
themselves can cause.

So, entirely forbidden derivatives can’t be the solution to the disadvantages. Even though
they can be enormous. But these derivatives are complicated and they are in some
cases not even understood by the banks. In a way, there should be a way to better
control the use of derivatives. So that no one can misuse the instrument in a way so that
the whole economy is at risk.

You can’t take away the speculation either. This is in the end a risk and reward
business. So to get a reward you have to take a risk, for example by speculating in
derivatives. But of course, if some institution shows a pattern of misusing this
opportunity. It should be possible to at least limit their ability to do so.
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