Derivatives Market Risk Analysis

Financial markets have evolved over the years and now there is an array of products that is widely used by the market players, known as the Financial Derivatives which includes swaps, futures, forwards, option, etc. A derivative is nothing but a financial instrument that derives its value from an underlying asset or assets.

Prior to the financial crisis in 2008, the use of derivatives came under scrutiny because several well known companies made huge derivative related losses – Procter & Gamble lost $150 million in 1994, Barings Bank lost $1.3 billion in 2005, Long Term Capital Management Company lost $3.5 billion in 1998, the Hedge Fund Amarnath lost $6 billion in 2006,Socieite General lost euro 5 billion in 2008.

With the use of derivatives,

Market Risk – it is basically the risk associated with fluctuations and changes in the dynamic markets

2. Counterparty Risk or Credit Risk – it is the risk that arises if one of the parties involved in the derivative trade defaults and fails to meet the contract obligations

3. Liquidity Risk - it is the risk that arises if the investors decide to close out the contract prior to maturity

In order to avoid the risks, it becomes highly imperative that the derivatives market is properly regulated. The reasons below further strengthen the argument:

1. Warren Buffet quoted, “Derivatives are financial weapons of mass destruction, carrying dangers that are potentially lethal.” Derivatives played an important role in the beginning of the Financial Crises in 2007. AIG took a risky position in derivatives and did not keep sufficient capital as a safeguard against the potential losses. Ultimately , the company’s large derivative exposure resulted in its bankruptcy and a government bailout to prevent the parties involved from taking losses, thereby causing further financial instability. After the financial crises, several reforms were introduced to strengthen the regulation of these risky products such as the Dodd Frank Wall Street Reform, Consumer Protection Act of 2010, Volcker Rule, which showed that the regulation of derivatives was something that cannot be

As discussed in the first question, banks are a crucial part of the economy and they use largely use derivatives to hedge the risks. During Lehman Brothers meltdown, banks did not fully understand the level of losses that could incurred on derivatives trade with Lehman and others and as a result, it created great panic in the financial markets. Therefore, it is important to have clear rules regulating these risky products

3. Derivatives can be considered one of the ways to share or distribute risks. It is requires financial engineering of different products and there is no fixed contract/combination that will guarantee profits. In order to prevent the market players to take a highly risky position, it is necessary that certain rules are set for trading in derivatives.

4. Derivatives may be misused by the market speculators. Derivatives are often referred as “razors” and with increased use of derivatives, the risk of misuse also increases

Derivative market is primarily regulated by SFC and HKMA, where SFC is responsible for overlooking market misconducts and HKMA ensures stability and development of financial infrastructure. The present provisions provide an adequate framework for the regulation of derivative markets by enacting laws and regulations such as:

1. Risk Disclosure Rules

2. Prudential Supervision

3. Adoption of IOSCO Guidelines (which primarily focus on efficient risk management