With Reference to the 2007 Global Financial Crisis, Explain the Pitfalls Associated with Derivatives
Introduction This essay explains the pitfalls associated with derivatives instruments by making reference to the 2007 Global Financial Crisis. Derivatives are financial securities that are linked to a specific instrument or indicator or commodities called underlying instruments (Hull, 2009). There are as many derivatives as they are underlying instruments. Derivatives are essentially financial contracts which are entered into between two parties with respect to some other underlying instruments. Since they are contracts entered into with respect to underlying assets they do not have value on their own standing but derive it from that of instruments upon which they are entered into. According to the IMF (2010), even though it’s true that derivatives are linked to the value of underlying instruments, transactions in derivatives are separate transactions from those of underlying instruments upon which derivatives are based. This means that derivatives are financial securities with own roles, advantages and disadvantages which are distinct from those of underlying instruments.
The 2007 Global Financial Crisis There are a number of causes attached to the global financial crisis that saw the meltdown of many financial institutions around the world. For the purpose of this essay we consider one of those causes which is linked to trading in derivative instruments. According to Ellis (2009) the misperception and mismanagement of risk is one of those causes. This misperception and mismanagement of risk particularly refers to issues which surrounded mortgage backed securities (MBS) on the wake of the crisis. Mortgage Based Securities are derivatives because their value is secured, or backed, by the value of an underlying bundle of mortgages. The boom in the housing market in the U.S. accentuated the use of derivatives (MBSs). However, most derivative users did not comprehend these instruments to an extent that they never really understood the risk they were assuming by
The 2007 Global Financial Crisis There are a number of causes attached to the global financial crisis that saw the meltdown of many financial institutions around the world. For the purpose of this essay we consider one of those causes which is linked to trading in derivative instruments. According to Ellis (2009) the misperception and mismanagement of risk is one of those causes. This misperception and mismanagement of risk particularly refers to issues which surrounded mortgage backed securities (MBS) on the wake of the crisis. Mortgage Based Securities are derivatives because their value is secured, or backed, by the value of an underlying bundle of mortgages. The boom in the housing market in the U.S. accentuated the use of derivatives (MBSs). However, most derivative users did not comprehend these instruments to an extent that they never really understood the risk they were assuming by