Underlying Derivatives Of The Global Financial Crisis Finance Essay

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As we known, the global financial crisis really started to show its effects in 2007 and into 2009. Around the world, stock markets have fallen, large financial organizations have collapsed, and governments in even the wealthiest nations have had to deal with the problems of financial systems. There are many researches for the reasons of crisis, people were told they are about subprime mortgages, poor accounting standards, bad financial tools made by Wall Street and the investment banks, specifically Lehman Brothers' failure and AIG's credit default swaps. Derivatives are the underlying issues that link all of these items.

High Risk of Derivatives

Financial derivatives have many forms, including futures, forwards, swaps, options, and various combinations. Derivatives can reduce business risks, trade for profit, manage capital and funding costs, and alter the risk-reward profile of a particular item or an entire balance sheet. (Risk Management of Financial Derivatives Comptroller's Handbook January 1997).Due to their various functions, they have been used widely these years and become more and more popular all around the world, meanwhile, the characters of derivatives make them sensitive to external impacts, such as market price, liquidity, interest rates ,foreign exchange and credit. The volatility of those changes can influence derivative products easily. Unfortunately, these impacts change all the way, it is difficult for people to deal with all the sides when they make investment decisions. We can find out the main risks of derivatives are: price risk, foreign exchange risk, liquidity risk, interest rate risk and credit risk. At present, many financial organizations put derivatives together to create more sophistic derivatives, the innovation is over and improper because they are too difficult for people to understand, so people may be misled when they make investment decision.

The Improper Risk Management Caused Financial Crisis

Financial derivatives were the tools to manage risk at first, but when they work without the proper management system of controlling risk, it is quite easy to cause problem, such as crisis. In essence, what had happened was that banks, hedge funds and other financial organizations had become over-confident as they all thought they had figured out how to deal with risk and had ability to earn money efficiently by these tools. 'It was a result of a system heavily grounded in bad theories, bad theories, bad statistics, misunderstanding of probability and, ultimately, greed' Naseem Taleb said, who once was a famous options trader in America.¼ˆNaseem Taleb 2006¼‰ During these 10 years, the finance industry flourished as more people began to think of how to against the downsides when investing in something. For instance, once options could be priced, it became easier to trade. Combined with the widely use of computer and Internet, the derivatives market exploded quickly. As people became successful easily, they used derivatives not to reduce their risk, but to take on more risk to earn more money, they were making more gambling. The crisis came about when the market was speculative. Some institutions are paying for risk on margin so people do not need to pay the full price in advance; it means that people are able to make big profits with little capital. They forget about the probability of losses, pay no attention on setting limit for risk. The financial organizations ignore to calculator the risk and make warning for attracting more customers to buy the derivatives. Governments play the most important roles of monitor in financial system. They encourage the financial institutions to make innovation to heavily develop finance all the way. Unfortunately, before the crisis, they focused on benefit rather than the risk of excessive innovation. The imperfect laws give opportunity to many financial companies to earn illegal money. For example, the market for credit default swaps was enormous, exceeding the entire world economic output of $50 trillion by summer 2008(http://www.globalissues.org/). It was obvious that they were lack of controlling. The world's largest insurance and financial services company, AIG alone had credit default swaps of around $400 billion at that time. Furthermore, many of AIGs credit default swaps were on mortgages, which course went downhill, and so did AIG. Hence, the eventual bailout (now some $150billion) of AIG by the US government to prevent them failing.( http://www.cnbc.com/id/26680263/AIG_In_Crisis)

The Measures to Deal With The Crisis That Caused by Derivatives

The measurement of derivative-related risks is necessary for proper monitoring and control. All significant risks should be measured and integrated into a bank-wide or corporate-wide risk management system. (Risk Management of Financial Derivatives Comptroller's Handbook January 1997 P10-11) Every department must corporate with each other to manage risk of derivatives. For example, price, liquidity, foreign exchange, market analysis and so on need to be monitored by different departments in the institutions. Team work can efficiently collect useful information and set models for analyzing, so the final report could be more valuable. Management should ensure that the various components of the institution's risk management process are regularly reviewed and evaluated. (Risk Management guidelines for derivatives July 1994 p8)This review should take into account the changes in the activities and in the market environment, since the changes may have created exposures that we should pay attention on . Any material changes to the risk management system should also be reviewed. A system should set boundaries for risk and make ensure the positions whether exceed proper levels .The limit system should be consistent with the effectiveness of the organization's overall risk management process and with the adequacy of its capital position. (Actions Needed to Protect the Financial System Statement of Charles A. Bowsher 1994 P14) An appropriate limit system should permit management to control exposures and monitor risk-taking.

Conclusion

In conclusion, the over development and excessive use of financial derivatives is one of the most important reasons to cause this crisis. Some major financial institutions such as end-users, mutual funds, hedge funds, securities firms, and even banks have incurred derivatives-related losses, most of these losses are due to inadequate risk-management systems and improper control and supervision. To prevent that from happening, governments and financial organizations should focus on improving the risk controlling system and pay more attentions on structure, evaluation and risk limit.
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