Derivatives

Part 1: Please respond to the following:

• The use of derivatives within financial institutions is considered to have contributed the financial crisis in 2008. Assess how the use of derivatives contributed to significant losses in the financial industry, indicating how such losses may be mitigated in the future. Provide a rationale for your response.
• Some economists and bankers believe that derivatives make the market safer. Agree or disagree with this statement, providing support for your position.
• Please provide one citation/reference for your initial posting that is not your textbook.  Please do not use Investopedia or Wikipedia.

*** 100-200 WORDS

Part 2: Respond to classmate’s discussion below:

“A derivative is a financial security with a value that is reliant upon or derived from an underlying asset or group of assets—a benchmark. The derivative itself is a contract between two or more parties, and the derivative derives its price from fluctuations in the underlying asset.  The most common underlying assets for derivatives are stocks, bonds, commodities, currencies, interest rates, and market indexes, which are typically purchased through brokerages.

Big banks conduct the bulk of derivatives trading. Bankers generally assume that the likely risk of gain or loss on derivatives is much smaller than their notional amount. In the financial markets, analyzing derivatives is not a meaningful measure of the risk profile of the instruments, and many banks derivatives offset each other. We learned in 2008; it is possible to lose a large portion of the notional amount of a derivatives trade if the bet goes wrong, mainly if the bet is linked to other bets, resulting in losses by other organizations occurring at the same time.  The ripple effects can be massive and unpredictable. Banks don’t tell investors how much of the notional amount that they could lose in a worst-case scenario, nor are they required. Today’s cash-strapped governments are in no position to cope with another massive bailout.

Losses moving into the future may be mitigated by big banks providing total transparency in their practices in derivate trading.  We know this won’t happen, so there must be more government oversight.

I don’t agree that derivatives alone can’t be the determining outlier of whether they will make the market safer.  Derivative trading is just one tool in the toolbox that, if used correctly, could reduce risks.