Question

1. The volume of outstanding derivatives – particularly Over-the-Counter Derivatives -totalling over $500 trillion in Notional Amount is absolutely staggering.
   1. Point to 3 key reasons for this?
   2. Discuss the key risk to market participants in this OTC derivatives market.

Is the large size of the derivatives market dangerous for society at large?

Answer 1

a).

What is a Derivative?

Derivatives are contracts that allow businesses, investors, and municipalities to transfer risks and rewards associated with commercial or financial outcomes to other parties. Holding a derivative contract can reduce the risk of bad harvests, adverse market fluctuations, or negative events, like a bond default.

Derivatives derive their values based on the price, volatility, and riskiness of an underlying stock, bond, commodity, interest rate, or currency-exchange rate. Prices of derivatives fluctuate as the price of a reference security, commodity, bond, interest rate, or currency rises or falls in the market.\

Why Do Derivatives Matter?

Derivatives matter because they can reduce uncertainty for those for whom uncertainty is undesirable—like a farmer whose crops and profits depend on the cooperation of weather. Derivatives can’t change the weather, but they can change the financial implications of a drought.

Beyond the weather, businesses are exposed to volatility in the prices of commodities, currencies, and interest rates. The market prices for key inputs in the production process, like the price of crude oil or copper, fluctuate daily. Therefore, future costs and profits are uncertain.

Businesses can use derivatives to reduce exposure to unexpected tremors in the markets for key goods and key costs. For example, Hershey’s can use derivatives to protect their business from volatile cocoa prices; Southwest Airlines can ensure that rising jet fuel prices won’t ground their profits by entering into a derivative contract.

b). Risks in Derivatives are :-

Market Risk

Market risk refers to the general risk in any investment. Investors make decisions and take positions based on assumptions, technical analysis or other factors that lead them to certain conclusions about how an investment is likely to perform. An important part of investment analysis is determining the probability of an investment being profitable and assessing the risk/reward ratio of potential losses against potential gains.

Counterparty Risk

Counterparty risk, or counterparty credit risk, arises if one of the parties involved in a derivatives trade, such as the buyer, seller or dealer, defaults on the contract. This risk is higher in over-the-counter, or OTC, markets, which are much less regulated than ordinary trading exchanges. A regular trading exchange helps facilitate contract performance by requiring margin deposits that are adjusted daily through the mark-to-market process. The mark-to-market process makes pricing derivatives more likely to accurately reflect current value. Traders can manage counterparty risk by only using dealers they know and consider trustworthy.

Liquidity Risk

Liquidity risk applies to investors who plan to close out a derivative trade prior to maturity. Such investors need to consider if it is difficult to close out the trade or if existing bid-ask spreads are so large as to represent a significant cost.

Interconnection Risk

Interconnection risk refers to how the interconnections between various derivative instruments and dealers might affect an investor's particular derivative trade. Some analysts express concern over the possibility that problems with just one party in the derivatives market, such as a major bank that acts as a dealer, might lead to a chain reaction or snowball effect that threatens the stability of financial markets overall.