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