Financial Markets and Investments

Derivatives & Hedging – A Nightmare for Risk Managers?(S. Mandgi)

A derivative is a financial package which has no asset value of its own but gains or looses value due to the assets that gain or loose value which form a part of that financial package. A derivative could be formed out of one or many assets in various proportions such as currency, gold, stocks, options, futures, mutual funds, treasury bonds, corporate bonds, commodity futures, mortgage etc to name a few.

The risk of the derivative actually depends on its underlying assets (simply called underlying). So where is the risk in these derivatives ?

If you are a buyer , your risk is limited to the premium and the gains could be unlimited. If you are a seller you gain is limited to the premium paid by the buyer but the loss can be unlimited.

But the bigger risk in these derivatives is that the hierarchy of derivatives being a part of other derivatives in a chain from bottom to top. The bottom derivative losses its asset value due to systemic markets, poor economic conditions, poor climatic conditions, conflicts or corporate failure. This in turn results in the other derivatives in the derivative chain above also loose their value.

We can see that the losses are multiplied in proportion by factors proportional to the derivatives in the chain. The losers are global investors , financial institutions and companies which in turn have a drastic impact on markets and economies of countries.  The impact shocks are truly global. What makes these impacts significant is that it takes quite a while to trace these losses and recover from them. But the biggest loss which is more then the financial loss is the loss in investor confidence and brand value which erodes significantly and takes a lot of time to re-build ( if you have survived the crisis).

Derivatives can also be extremely good opportunities for profits when the price of the underlying assets are the lowest, the derivatives are cheap and the risks of loss are extremely low. Once such opportunity claimed is the US mortgage market where it is estimated that the price of real estate should gain momentum in 6-12 months. However , with the instability in the European markets and the US banks asked to increase their cash base, it is doubtful that one would see huge investments in this asset immediately as of now.

However, to trade in derivatives investors needs
  1. Extremely good understanding of these financial instruments.                                   
    Have tools and technologies for precision trading
    Have very sound knowledge of macro economics and the global market 
    and lastly, but never the least, money to take that risk.