DERIVATIVES AND RISK

MANAGEMENT :

SUMMATIVE ASSESSMENT 1 :

Reflective essay :

“Derivatives are financial

weapons of mass
destruction”

STUDENT : LAMIAA LAHLOU

TUTOR : VIKTOR MANAHOV

10 / 11 / 2023
Introduc)on :

The world of finance is an intricate web, entwined with complex instruments that can
both stabilize and destabilize economies. At the heart of this complexity lie deriva>ves,
enigma>c en>>es that are indispensable yet poten>ally hazardous. My academic journey
through this course has led me to a deeper understanding of these instruments, par>cularly
through the detailed explora>on of Black-Scholes and Binomial pricing models, as well as the
prac>cal applica>ons of hedging with forwards, futures, and op>on contracts, but also by
igni>ng a fascina>on with the paradoxical nature encapsulated by Warren BuffeH's stark
warning, where he labeled deriva>ves as "financial weapons of mass destruc>on" (BuffeH,
2002). This essay is a reflec>ve odyssey into the essence of deriva>ves, recognizing their cri>cal
role in risk mi>ga>on and economic func>onality, while also acknowledging the risks that they
may harbor, capable of triggering financial upheavals.
This inves>ga>on is steered by the cri>cal insights of TeH (2009), who me>culously unravelled
the role of complex deriva>ves in precipita>ng the financial crisis of 2007-2009. In tandem, I
will engage with the theore>cal and prac>cal aspects of deriva>ves as detailed by Hull (2012),
whose work provided a comprehensive analysis of their usage in hedging and specula>on.
Moreover, I will contemplate the dynamic evolu>on of the deriva>ves market, as documented
by Stulz (2010), highligh>ng the innova>ve expansions and the stringent regulatory responses
that followed.
By delving into the economic ra>onale behind deriva>ves, their strategic use in risk
management, and their transforma>ve impact on global financial markets, this essay
endeavors to provide a nuanced perspec>ve on BuffeH’s cau>onary stance.

The importance of understanding the economics and mechanics of the

deriva)ves as well as their pricing principles :

Understanding the economics and mechanics of deriva>ves, as well as their pricing

principles, is fundamental for any finance professional naviga>ng the modern financial
landscape. Deriva>ves, by design, are financial instruments whose value is derived from the
value of an underlying asset, index, or interest rate. These instruments can be as

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straighWorward as a futures contract guaranteeing the sale of wheat at a future date or as
complex as an op>on on the future vola>lity of a stock index.

The economic ra>onale for deriva>ves lies in their capacity to allocate risk efficiently. As
posited by Arrow and Debreu in their pioneering work on general equilibrium theory, markets
are more complete when par>cipants can trade risks freely (Arrow and Debreu, 1954).
Deriva>ves expand market completeness by allowing for the trade of risks that are not
otherwise tradeable. This economic func>on underpins much of the financial system's
structure and dictates the need for finance professionals to grasp the core principles that guide
deriva>ve markets.

The mechanics of deriva>ves are equally intricate, varying considerably across different types
of instruments. For instance, the workings of a swap contract, where counterpar>es exchange
cash flow streams, differ markedly from those of a stock op>on, which gives the holder the
right, but not the obliga>on, to buy or sell a stock at a predetermined price. The complexity
increases with the introduc>on of leverage, where small movements in the underlying asset
can lead to dispropor>onately large changes in the deriva>ve's value, a principle well
elucidated by Black and Scholes in their op>on pricing model (Black and Scholes, 1973). This
model, which revolu>onized the financial industry, exemplifies the importance of
understanding deriva>ve pricing. It uses the concept of a "risk-free" hedge porWolio to price
op>ons in a way that is indifferent to the risk preferences of investors.

The pricing of deriva>ves is a science that requires proficiency in both advanced mathema>cs
and a deep understanding of financial markets. The Black-Scholes model, for example, relies
on the con>nuous adjustment of the hedge porWolio to maintain risk neutrality, an assump>on
that may not hold in all market condi>ons. Understanding the limita>ons and assump>ons of
such models is cri>cal for finance professionals, as mispricing deriva>ves can lead to significant
financial losses, as illustrated by the collapse of Long-Term Capital Management in 1998
(Lowenstein, 2000).

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Moreover, the pricing principles of deriva>ves are con>ngent upon the behavior of the
underlying asset and the market's percep>on of future uncertain>es. This is where the
'Greeks,' or risk measures such as delta, gamma, and theta, become crucial for professionals
managing porWolios of deriva>ves. They provide a quan>ta>ve framework to assess how the
price of an op>on reacts to changes in factors like the underlying asset's price, vola>lity, >me
decay, and interest rates.

In the context of financial markets, deriva>ves serve as a tool for price discovery, allowing
market par>cipants to express views on the future price movements of assets. This func>on is
central to the capital alloca>on process and underscores the necessity for finance
professionals to be adept in the valua>on and opera>on of these instruments.

The use of the deriva)ves instruments in risk management process for

two purposes: hedging and specula)on :

The u>liza>on of deriva>ve instruments in the risk management process for hedging
and specula>on stands as a testament to the versa>lity and potency of these financial tools.
Hedging, the prac>ce of mi>ga>ng risk, is a primary func>on of deriva>ves, allowing firms to
stabilize their financial outlook by locking in prices for commodi>es, securing interest rates, or
ensuring foreign exchange stability. Specula>on, conversely, involves assuming risk with the
prospect of profit, oben ac>ng as a catalyst for market liquidity and price discovery.
Understanding these dual applica>ons is crucial for finance professionals to employ deriva>ves
effec>vely and responsibly.

Hedging strategies can be observed across various sectors, from agricultural producers using
futures contracts to secure a selling price for their crops, to mul>na>onal corpora>ons u>lizing
currency swaps to protect against exchange rate fluctua>ons. These protec>ve measures are
not merely theore>cal constructs but essen>al prac>ces that safeguard against market
vola>li>es. For instance, the airline industry is known for using fuel hedges to stabilize cash
flows amidst fluctua>ng oil prices (Carter, Rogers, and Simkins, 2006). The effec>veness of such
strategies hinges on a comprehensive understanding of deriva>ves and their behavior under

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different market condi>ons. This knowledge enables finance professionals to design hedges
that align closely with the specific risk profiles of their firms or clients.

Specula>on, while oben viewed pejora>vely, serves a cri>cal func>on in financial markets by
providing liquidity and aiding in the discovery of the true price of assets. Speculators take on
risks that hedgers seek to avoid, beeng on future price movements to earn profits. The role
of speculators became par>cularly notable during the financial crisis of 2007-2009 when
traders speculated on the direc>on of the housing market via mortgage-backed securi>es and
their deriva>ves, contribu>ng to both market growth and the subsequent collapse (Financial
Crisis Inquiry Commission, 2011).

However, the dual use of deriva>ves is not without peril. The very features that make
deriva>ves powerful tools for risk management can also amplify risks when used imprudently,
especially in specula>ve ventures. The collapse of Barings Bank due to unauthorized
specula>ve trading in deriva>ves by Nick Leeson is a stark reminder of the poten>al
consequences of inadequate oversight and control (Fay, 1996). The need for comprehensive
risk management strategies and regulatory oversight becomes evident to prevent such misuse.

In the professional prac>ce of finance, an acute awareness and understanding of the delicate
balance between hedging and specula>on are vital. This balance ensures that deriva>ves serve
their intended purpose of risk management, rather than becoming vehicles for reckless risk-
taking. Finance professionals must be adept in evalua>ng deriva>ve strategies, discerning the
fine line between prudent risk management and specula>ve excess. Educa>on and experience
in this domain are indispensable for developing the necessary skill set to navigate the nuanced
world of deriva>ves.

The role of deriva)ves in the financial crisis of 2007-2009 :

The role of deriva>ves in the financial crisis of 2007-2009 provides a cri>cal perspec>ve
for understanding not only the power of these instruments but also their poten>al to disrupt
global financial stability. Deriva>ves, lauded for their ability to spread risk, came under intense

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scru>ny following their central involvement in the crisis. Their role underscores the
significance of transparency, regula>on, and the careful management of systemic risk in
financial markets.

The financial crisis illuminated how deriva>ves, par>cularly mortgage-backed securi>es and
their complex offspring—collateralized debt obliga>ons (CDOs)—could act as catalysts for
widespread economic turmoil (Financial Crisis Inquiry Commission, 2011). These instruments,
ini>ally created to distribute and manage the risk of mortgage default, became exceedingly
opaque and complex. This complexity, coupled with a lack of understanding among some
market par>cipants, including finance professionals, obscured the true risk profile of these
deriva>ves (TeH, 2009). The crisis highlighted the consequences of mispricing risk and the
contagion effect that can occur when interlinked deriva>ves unravel, as detailed by Lewis
(2010) in his examina>on of the crisis through the eyes of those who bet against the market.

The failure of financial giants like Lehman Brothers and the near-collapse of other ins>tu>ons
exposed the systemic risks that deriva>ves could pose when used imprudently. These events
showcased the need for finance professionals to possess a deep understanding of deriva>ves,
not just in isola>on but within the broader context of the financial system. The crisis spurred
a reevalua>on of risk management prac>ces and a push for enhanced regulatory frameworks,
as recommended by the Dodd-Frank Wall Street Reform and Consumer Protec>on Act (Dodd-
Frank Act, 2010).

Reflec>ng on the role of deriva>ves in the crisis has become an integral part of financial
educa>on and prac>ce. The lessons learned have led to a more cau>ous approach to
leveraging and risk-taking with deriva>ves. Finance professionals are now more aHuned to the
systemic implica>ons of their ac>vi>es and the importance of adhering to robust risk
management frameworks. This knowledge is cri>cal for preven>ng a recurrence of the
condi>ons that led to the crisis and for fostering a resilient financial system.

So the financial crisis of 2007-2009 serves as a profound lesson on the poten>al threats of
deriva>ves when they are poorly understood, improperly managed, or inadequately

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regulated. The crisis has ins>lled in finance professionals a recogni>on of the necessity to
thoroughly comprehend these instruments and the importance of maintaining systemic
oversight. As the financial industry con>nues to evolve, with deriva>ves playing a significant
role, the wisdom gleaned from past missteps becomes a guiding force for prudent and
informed financial prac>ce.

Timeline: Evolu-on of the European debt crisis

Source : Yahoo Finance Canada

The need for finance professionals to understand deriva)ves

instruments :

The intricate nature of deriva>ves demands a comprehensive understanding from

finance professionals, transcending beyond mere familiarity with basic financial instruments.
The necessity for proficiency in the mechanisms of deriva>ves trading, their market structures,
and valua>on principles is well-documented in academic and professional circles (Hull, 2012;
Stulz, 2010). My learning trajectory through this course has illuminated the profound impact
that deriva>ves exert on the financial markets and the cri>cality of their prudent management.
The interconnectedness of financial disciplines suggests that knowledge of deriva>ves should
not be siloed among specialists but should be a founda>onal competence for all finance

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professionals (Tufano, 1996). The expansive reach of deriva>ves, as evidenced by their role in
the global financial crisis, indicates that their effects are not isolated to trading desks but
extend to the en>re financial ecosystem (Financial Crisis Inquiry Commission, 2011).

The proposi>on that such intricate knowledge should remain the purview of
specialized deriva>ve traders is to undervalue the complex web of today's financial markets
where deriva>ves play a central role (Stulz, 2004). Deriva>ves intersect with various financial
opera>ons, including corporate finance, investment management, and market regula>on,
making their understanding essen>al across the financial sector (Smithson, 1998; Stulz, 2004).
This course has for>fied the convic>on that irrespec>ve of one's role—whether in crabing
corporate hedges, managing porWolios, or overseeing market conduct—the acumen to decode
deriva>ve valua>ons and their market implica>ons is indispensable. Imbuing all finance
professionals with this cri>cal exper>se aligns with calls for greater transparency and stability
within the financial system (Financial Crisis Inquiry Commission, 2011).

Comments : The COVID-19 pandemic saw deriva?ves market values soar by 33% in six months to $15.5
trillion by mid-2020, as market vola?lity spurred trading

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Conclusions :

In revisi>ng the mul>faceted world of deriva>ves, I have come to appreciate their inherent
complexity and the cri>cal role they play in financial markets. Warren BuffeH’s depic>on of
deriva>ves as "financial weapons of mass destruc>on" (BuffeH, 2002) has served as a catalyst
for a deeper inquiry into the dual nature of these instruments. The course's rigorous
examina>on of economic theories and mathema>cal models has been pivotal in
deconstruc>ng the nuances of deriva>ves pricing and their prac>cal applica>on in the spheres
of hedging and specula>on. The historical lens provided by the analysis of the 2007-2009
financial crisis has ins>lled in me a heightened sense of prudence, par>cularly in recognizing
the systemic risks that deriva>ves can pose.

Reflec>ng upon this educa>onal endeavor, I am acutely aware of the transforma>ve effect it
has had on my approach to financial decision-making. The course has equipped me with a
robust toolkit for analy>cal thinking, enabling me to scru>nize financial instruments not just
for their surface value but for their underlying economic implica>ons. It has underscored the
impera>ve need for a vigilant and ethically grounded professional prac>ce in finance, where
the welfare of the broader economy is held paramount.

As I progress in my financial career, the insights garnered from this course will serve as guiding
principles. The ability to dissect complex financial instruments, understand their market
implica>ons, and apply this knowledge to protect and grow financial porWolios is an invaluable
skill set. This intellectual arsenal, for>fied by an ethical compass, will be the cornerstone upon
which I will build my professional prac>ce, ensuring that my contribu>ons to the field of
finance are both prudent and progressive.

Word Count : 2024

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References :

Arrow, K.J. and Debreu, G. (1954). Existence of an Equilibrium for a Compe>>ve Economy.
Econometrica, 22(3), 265-290.

Black, F. and Scholes, M. (1973). The Pricing of Op>ons and Corporate Liabili>es. Journal of
Poli>cal Economy, 81(3), 637-654.

BuffeH, W. (2002). Warren BuffeH on the Stock Market. Fortune.

Carter, D.A., Rogers, D.A., and Simkins, B.J. (2006). Does Hedging Affect Firm Value? Evidence
from the US Airline Industry. Financial Management, 35(1), 53-86.

Dodd-Frank Wall Street Reform and Consumer Protec>on Act, Pub. L. No. 111-203, § 929Z
(2010).

Fay, S. (1996). The Collapse of Barings. W.W. Norton & Company.

Financial Crisis Inquiry Commission. (2011). The Financial Crisis Inquiry Report: Final Report of
the Na>onal Commission on the Causes of the Financial and Economic Crisis in the United
States. U.S. Government Prin>ng Office.

Hull, J. C. (2012). Op>ons, Futures, and Other Deriva>ves. 8th ed. Pren>ce Hall.

Lewis, M. (2010). The Big Short: Inside the Doomsday Machine. W. W. Norton & Company.

Lowenstein, R. (2000). When Genius Failed: The Rise and Fall of Long-Term Capital
Management. Random House.

Smithson, C. (1998). Managing Financial Risk: A Guide to Deriva>ve Products, Financial

Engineering, and Value Maximiza>on. McGraw-Hill.

Stulz, R. M. (2004). Should We Fear Deriva>ves? Journal of Economic Perspec>ves, 18(3), 173-
192.

Stulz, R. M. (2010). Credit Default Swaps and the Credit Crisis. Journal of Economic
Perspec>ves, 24(1), 73-92.

TeH, G. (2009). Fool's Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted
by Wall Street Greed and Unleashed a Catastrophe. Free Press.

Tufano, P. (1996). Who Manages Risk? An Empirical Examina>on of Risk Management Prac>ces
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