A view at the Pros and Cons of Derivatives

Keith (1997) mentioned that derivatives security market has grown over the past years. However, many occurrences question if it offers more advantages or disadvantages because of the risks that are associated with derivatives trading. For instance, as Keith (1997) explained, the stock market crash in 1987, from a perspective was blamed on “portfolio issuance strategies that used future markets. The crash was associated with the use of derivatives by firms such as Procter & Gamble ($137 million), Metall Gesellschaft ($1 billion), Barings PLC ($1.3 billion), and Orange County – California ($1.7 billion). To which, led to fear among some market participants that derivatives trading is a risky activity that could result in a widespread disruption of the financial system.” Although, one should also note that amidst the disadvantage and risk, it does provide advantages and benefit to the organization, investors and the economy. And this is when one views derivative securities that include, forwards and futures, options, exchange, and swaps that may not be possible otherwise. The advantages of derivatives show its strengths, by distributing risk across investors and firms, which can be used to lower the cost of diversification. More so, it helps to reveal information to investors, through ‘price’ that will contribute to making the financial market more stable. The derivatives market has been successful as an institution because it strengthens the financial market and makes it more efficient. Implying that lending and borrowing can take place at a lower cost when compared to its absents, and this is because derivatives reduce the cost of the transaction.

For example, startups can quickly raise capital for their business at a lower rate, when the financial market is efficient, which in turn lead to faster economic growth. The application of derivative involves two parties, where one party receives a claim on ‘underlying assets or on the cash value of the assets,’ which the other party must fulfill the obligation to meet the liability. However, Warren Buffett does not agree with the framework and view “derivatives as time bombs, for both parties involve” (Buffet, 2002). This is because of the duration of derivatives are not constant, and attributed to multiple variables that are tied to their value. Thus, the moment one party tries to meet his/her obligations, it may not offer value to the other parties involved. And brings the most recognized disadvantage, which is ‘difficulties’ in finance, especially for smaller agencies. For example, a company completed its obligation, to a bigger organization. And completes this for multiple agencies, because of the time it will take to mature; usually 20 years, the cash flow of the organization is affected significantly. Notably, financial professionals are unable to manage derivative instrument, which brings terrible consequences. Referring to Rodrigo (2012) example, where the writer illustrated that “the massive economic losses caused by the use of derivative, is five to six small firms, in India, have engaged in a lawsuit. With private­-sector banks, because of improper handling of the derivative product, causing ten million losses on derivative instruments (Reuters India, nd).

In the second place, if the prediction is incorrect, a commodity price or foreign exchange future or forward contract will raise the purchase costs for small firms, for that this kind of derivatives sets the future amount due to a fix, i.e. whatever the future prices or exchange rate would be.” And when there is an odd arrangement, the interest rate of derivatives will cost fund fee to be on the increase. And attributing to the fact that interest rates of derivatives have set a limit on the funding cost. And because of the mentioned, when the interest rate goes downwards, the funding cost will increase, which will lead to financial crises for a small organization.

Further Reading  

Buffet, W. (2002) Berkshire Hathaway annual report [Online]. Availablefrom:http://www.fintools.com/docs/Warren%20Buffet%20on%20Derivatives.pdf [Accessed: December 3, 2015]

Keith S., (1997) The Economic Benefits and Risks Of Derivative Securities Online]. Available: https://pdfs.semanticscholar.org/b32e/9fe71ad47164919dccaae16bb949ef0780b9.pdf [Accessed: December 3, 2015]

Rodrigo (2012) Analyze the advantages and disadvantages of financial derivatives used by small companies and make suggestions for small companies to better take advantage of financial derivatives [Online] Available: http://writepass.com/journal/2012/11/analyze­the­advantages­and­disadvantages­of­financial­derivatives­used­by­small­companies­and­make­suggestions­for­small­companies­to­better­take­advantage­of­financial­derivatives/ [Accessed: December 3, 2015]

Reuters India (nd) India Axis Bk: clients’ notional derivative loss $169mln [Online] Available: http://uk.reuters.com/article/rbssFinancialServicesAndRealEstateNews/idUKBOM14592320080421 [Accessed: December 3, 2015]