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Derivatives

 - Stock Options

 - Stock Warrants

 - Interest Rate Swaps

 - Interest Rate Caps, Floors
    and Collars

 - Swaptions

 - Futures and Forward
    Contracts

 - Managed Futures

 


Derivatives

Derivatives are financial instruments that derive their value from a completely different instrument. The standard types of derivatives are: options, warrants, interest rate swaps and futures. I believe that this is the area, in my generation, that has the potential to “blow up” the financial markets. The bottom line is that the baby boomers are not satisfied with low returns and are taking an inordinate amount of risk to obtain better returns. This emotional need to push the envelope to the limit has consequences.  What’s happening is money is chasing high returns. For now, Sarbanes-Oxley has restricted the movers and shakers of industry. The lawyers and auditors are now firmly in control of business! Mediocre returns are being sold as reasonable and acceptable. The so called “smart and aggressive” money is bypassing the main street stock, bond, and mutual fund investments and is moving to the hedge funds and private companies. The shift in business has taken derivatives to the forefront of investing strategies. While many derivative products are value-added and have a true economic purpose, like interest rate swaps, some are purely speculative with unlimited leverage. "It is just mind-boggling as to what possesses people to create and enter into some of these contracts.  A variety of contracts settle decades in the future and are pegged to various stock prices, indexes, and currencies." The landscape is scattered with derivatives that ran astray: Enron, Long-Term Credit Management, Metallgesellshaft, China Aviation, more recently Refco, just to name a few. Using derivatives for risk management, hedging and locking in profits is fine; taking unhedged leveraged positions, however, is risky and can lead to substantial losses.  

Banks employ derivatives to hedge their business risks; they are big users of interest rate swaps. They issue long-term fixed rate loans, like mortgages or leases, which initially are funded by floating rate debt. Subsequently, they lock in their profits, and match fund their incoming and outgoing cash flows by swapping floating rate debt to fixed rate debt. Hopefully, bank hedging strategies will perform as intended under distress conditions. Hedge funds, on the other hand, are under a great deal of pressure for high returns, and are considered by many to be using derivatives to speculate on price movements. The concern is that they may expose themselves, and the financial markets, to an unhealthy level of risk. The doomsday scenario is that if a large hedge fund incurred large losses it could result in not meeting its counterparty obligations, causing a ripple failure among the counterparties. This could cause a collapse in the financial markets. It’s equivalent to an individual selling stock, only to find out that the buyer is unable to pay for the security. If this ever happens, pandemonium will follow. A safety net is needed to prevent a catastrophic rippling through the financial system if a party fails. Safeguards need to be established before a calamity occurs.

Please choose the subject of your interest from below or from the left side column.

 - Stock Options
 - Stock Warrants
 - Interest Rate Swaps
 - Interest Rate Caps, Floors and Collars
 - Swaptions
 - Futures and Forward Contracts
 - Managed Futures

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