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
- 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.
