Derivatives as a way of mitigating financial risk Literature review

Derivatives as a way of mitigating financial risk - Literature review Example Certain creditor protection rules are extended to these derivatives and this helps to increase their security and reduce financial risks. The other side is that with excessive credit protection norms, capital markets will under price the credit risks. This means that risks that should be valued at say 100 Pounds will be considered to be worth only 80 Pounds. This increases systemic risks and helps to propagate credit booms. The reason is that the lending firm considers a risk of 80 Pounds worthwhile while extending loans whereas if the assets had a risk of 100 Pounds, the lending firm would reduce the amount lent (Chance and Brooks, 2010). The paper will examine how derivatives based on standard assets and bonds can be used as a method of mitigating risk. 1.1. OTC and ETD and risk management Two main types of derivates are available and these are over the counter derivatives – OTC’ and ‘exchange traded derivative contracts’ - ETD. OTC instruments are privat ely traded between two parties and the exchange is not involved. Instruments traded included forward rate agreements, exotic options, swaps and other types. The main constituents and partners in the OTC markets are banks, financial institutions and hedge funds. The market is estimated to be worth 708 trillion USD and most of it occurs in private without any public listing and declaration. Out of this amount, 67% is for interest rate contracts, 9% are foreign exchange contacts while credit default risk make up 8% and ht rest is made up of equity contracts, commodity contracts and others. Since there is no external counterparty that acts as a central agency and mandates the exchange of contracts some, element of risks can exist. These risks can occur if either of the party cannot or will not honour its commitments to pay the contracted amount. This possibility is rare since banks and financial institutions are expected to be stable. Hence, derivatives are used to make the appropriate profits in ITC markets (BIS, 2011). In the case of exchange trade derivatives, these instruments traded through the derivatives exchange serve as an intermediary for the transactions. The exchange takes a certain percentage from both parties as the initial margin. The combined revenue of the world's derivatives exchanges was about 344 trillion USD. Examples of instruments that form ETD are futures contracts, interest rate and index products, convertible bonds, and warrants. These instruments can be traded only through special derivatives exchanges such as KOSPI Index Futures & Options, Eurex, Chicago Mercantile Exchange, New York Mercantile Exchange and others. These instruments have certain guaranteed prices on the maturity value and the guarantee is given by the derivatives exchange that has already taken a margin from both parties. This helps to manage risks. Due to low risks, returns obtained are also less and may range in the 3 to 6% range (Bartram, et all, 2011). The derivativ es market and risks are different from the equity market where individuals can take up stock trading on their risk. The firm whose stocks are traded in the stock market will not give any assurance about the price stability or that a certain amount of dividend is payable. The stock market exchange also does not regulate the transactions between the parties. Therefore, if the price falls, the risk is borne by the party. In effect, derivatives markets transfer the risk from parties that aver risk