This work is to discuss the role and power of derivatives in the global financial markets and their ability to reduce, diversify and enhance risks associated with international capital flows. During the last two decades derivatives, as fiscal instruments, experienced enormous growth and gained increasingly of importance. This is mainly due to their ability to allow the spreading of risks in cross border capital movements, making such investments more appealing and the diversification of portfolios more likely. Yet, derivative markets are controversial because they are not well known outside a small group of specialists. Most people look at them with suspicion and focus on their role as highly effective instruments for speculation. Given the leverage they provide fortunes can be made or lost in the wink of an eye.
Although derivatives do not create anything it will be shown in the course of this study that the importance of derivatives lies in the fact that they can be used to reduce, diversify and control uncertainty and risks associated with various corporate activities, thus creating substantial benefits as well as complexities. Section one is going to define the most common derivative products before addressing their general purpose followed by exemplifying two principal risks aligned with the use of derivatives, namely credit- and market risk.
Subsequently this works is going to discuss the positive as well as the negative effects derivatives may have on banks and investors. Sections five, six and seven will then illuminate systematic predicaments, address risks and eventually conclude after having considered the entanglement and market share of derivatives. Warren Buffett, Forbes-listed as the richest person in the world, has called credit derivatives financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal. Nominally they are insurances against defaults, but they encourage greater gambles and credit expansion, which are moral hazards whereas Alan Greenspan, on the other hand, observed that derivatives have come to play an exceptionally important role in our financial system and in our economy. These instruments allow users to unbundle risks and allocate them to the investors most willing and able to use them. It is this study’s object to illuminate the complexity of derivatives and exemplify both, their advantageous and unfavourable but yet undeniably powerful characteristics.
Table of Contents
I. Introduction
II. Discussion
1. Defining derivatives
2. General purpose of derivatives
3. Addressing the main risks
4. Derivatives: leading to complex banking & immediate effects for investors
5. Systemic predicaments arising from derivatives
6. Extensive popularity of complex derivative products
7. The Power of Derivatives–derived from extensive market share and entanglement
III. Conclusion
Research Objective and Core Topics
This paper examines the role and influence of derivatives within global financial markets, focusing on their capacity to manage and redistribute risks while simultaneously creating systemic complexities and financial instability. It investigates how these instruments have evolved into indispensable yet controversial components of modern capital accumulation.
- The evolution and definition of various derivative instruments.
- Risk management strategies, specifically credit and market risks.
- The impact of complex derivatives on banking behavior and investor outcomes.
- Systemic risks and the entanglement of derivatives in the global economy.
Excerpt from the Book
1. Defining Derivatives
No matter whether derivatives are traded over the counter (OTC) or on exchange, they are very complex products which are hard to define. “Credit derivatives are negotiated in a decentralized, over the counter market, thus quantifying and documenting the market’s spectacular growth in recent years is no easy task.” They differ in application and content depicting “the principal instrument that speculative capital uses in the global marketplace. From the viewpoint of the market, they appear to be necessary and natural because they are motivated by the risks associated with the connectivites lying at the heart of globalization.” Initially derivatives were mainly traded publicly whereas nowadays, approximately eighty percent of the market is traded over the counter. As illustrated in the chart below, the OTC market has grown continuously and decreased only in 2008 as a result of reduced market activity after the global credit crunch.
Exchange traded contracts are standardised contracts whereas OTC derivative markets offer customized and more flexible products. Yet, they have ample common features allowing them to be described as fiscal instruments with structures and characteristics that refer to financially significant external items. As such, derivatives originate from external items, often called underlyings, which define their intrinsic value as tradable assets. Underlying assets or market variables can range from cash, stocks and bonds to tangibles or intangibles like currency rates, credit quality or interest rates. “A credit derivative is a financial instrument whose value is derived from an underlying market variable reflecting the credit risk of a public or private entity. The objective of credit derivatives is to isolate and price the credit risk from an underlying instrument.” Thus, the value of the derivative depends substantially on the quality of its underlying asset which demonstrates its nature as an obligation or right, rather than a tradable product. It is this obligation or right that obtains the derivative’s value, like a real asset, allowing it to be traded. Therefore, derivative products are formed by contracts that may be implemented by physical- or cash settlements.
Summary of Chapters
I. Introduction: The introduction outlines the growth and controversy surrounding derivatives as financial instruments used to manage uncertainty in international capital flows.
II. Discussion: This section provides a comprehensive breakdown of derivative definitions, their functions in risk management, and the systemic challenges they pose to global financial stability.
III. Conclusion: The conclusion summarizes the dual nature of derivatives, noting their utility in corporate finance and their potential to act as dangerous, opaque instruments that threaten the broader financial system.
Keywords
Derivatives, Global Financial System, Credit Risk, Market Risk, Over-the-Counter, Hedging, Speculation, Financial Stability, Banking Intermediaries, Systemic Risk, Capital Flows, Financial Instruments, Credit Crunch, Leverage, Corporate Finance
Frequently Asked Questions
What is the primary focus of this paper?
The paper focuses on the role and power of derivatives in the global financial system, analyzing how they help manage risk while creating systemic complexities.
What are the central themes discussed?
Key themes include the definition and purpose of derivatives, the management of credit and market risks, and the systemic consequences of their widespread use.
What is the main goal of the research?
The goal is to illuminate the complexity of derivatives and explain both their advantageous and unfavorable characteristics in the context of global capital.
Which methodology is used?
The study utilizes a theoretical and analytical approach, drawing on established financial literature and market data to evaluate the impact of derivative products.
What topics are covered in the main body?
The main body covers definitions of derivatives, risk management strategies (arbitrage, hedging), the role of banking institutions, and the systemic threats exposed during financial crises.
Which keywords define this work?
The work is defined by terms such as financial derivatives, risk management, global financial system, systemic risk, and off-balance-sheet activities.
What role do OTC markets play in derivative trading?
OTC markets represent the majority of derivative trading, offering highly customized products that often lack transparency compared to exchange-traded contracts.
How did Basel accords influence derivative usage?
Financial institutions utilized complex derivative instruments and Special Purpose Vehicles (SPVs) to circumvent Basel capital requirements, effectively moving risk off their balance sheets.
Why are credit derivatives sometimes called "financial weapons of mass destruction"?
The term reflects concerns that credit derivatives encourage reckless speculation and credit expansion, carrying hidden dangers that can trigger lethal systemic shocks.
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- Maximilian A. Killinger (Autor:in), 2009, The Power of Derivatives in the Global Financial System, München, GRIN Verlag, https://www.grin.com/document/142508
