- May 29, 2020
Financial Markets and Derivatives
FinancialMarkets and Derivatives
FinancialMarkets and Derivatives
Derivativesare financial contracts between the buyer and seller regarding atransaction that is to be fulfilled at a future time. Derivatives inthe global market include futures contracts, forward contracts,swaps, options, and commercial mortgage-backed securities. There aremany developed financial instruments in the global market includingthe financial derivative. Countries should employ financialderivative to hedge the economic risk however, they need to becareful when implementing it to prevent the losses that result frompoor management. The policy makers should, therefore, have a goodunderstanding of the financial derivatives to avoid the instances oflosses.
Theuse of derivatives to hedge risk
Thefinancial instruments make it easy to share risks, a practice whichis also referred to as hedging. Hedging enables corporate andfinancial institutions to use the derivatives to diversify risks andprotect themselves against changes in prices of raw materials,interest rates and exchange rates. Every type of derivativeinstrument is uniquely used to hedge risks. The use of derivativesmostly requires a well-developed financial market. There have beenseveral innovations leading to the growth of the derivatives marketover the past decade (In Hirsa & In Neftci, 2014).
Aforward contract is a customized financial contract between twoindividuals seeking to purchase or sell an item at a given price at aspecified time in future. The delivery is scheduled for a futuredate, and the obligation is fulfilled at that date. Forwardcontracts are used by many corporate organizations to hedge the riskof the exchange rate, interest rate and fluctuation of prices ofcommodities. For instance, firms that deal with internationalbusiness transactions are prone to the volatility of foreign exchangerates. The exercise rate is the rate that is agreed upon by theparties, and they are obligated to fulfill it at the specified date.Future contracts are similar to a forward contract, despite the factthat futures transactions occur on a futures exchange market (InHirsa & In Neftci, 2014). For instance, an oil producer may takeup a futures contract to sell a barrel of oil at $39 by setting theprice a year from the contract date to be the current price of abarrel of oil say U.S $39. The spot price after a year from thecontract date may have decreased or increased, but the producer wouldstill sell the product at U. S $39. This shields the producer frommaking losses if the price of a barrel of oil drops. In a swaptransaction, the two parties involved in the contract exchange thefinancial instruments in an efficient, beneficial way to ensure thatboth parties share the risk. Apart from hedging, derivatives canserve as profitable special purpose channels for the investors. Swapsare also used, especially the interest rate swaps however, they donot trade on exchanges. For interest rate swap the principal does notexchange hands. A company with an unfavorable interest rate on a bondwould have to find another company willing to pay the principal forthe bond instrument at the specified rate. In interest rate swap, ifthe rates rise the company paying up the notional principal makes aprofit but if the rates reduce the bond holder gains. This exchangeis usually done through an intermediary such as an investment bank(In Hirsa & In Neftci, 2014).
Instanceswhere the use of derivatives resulted in big losses
Derivativeshave previously been misused, and this has led to gross financialmarket failure causing most economies to collapse through improperuse of derivatives as investment channels. The most recent occurrencewas when the Lehman Brothers collapsed causing an economic shock inthe United States. This was as a result of the misuse ofmortgage-backed securities thus creating a real estate bubble thatgave people the hope of being homeowners however, it proved to be abad move for the U. S economy. The use of low rated mortgagesecurities by the investment firms caused a recession. The stockprices of most companies plummeted and became unattractive to theinvestors. This collapse caused the global bank meltdown. Withmarkets having learned from the Lehman ordeal more banks andfinancial institutions are more prudent in making their financialinvestment decisions especially in the most volatile market segments(United States, 2011).
Thefact that derivatives solely depend on the value of the underlyingasset makes them very unsafe and risky especially when the markettrends are not favorable. The Deutsche Bank has had its share priceplummeting by almost 50% over the past year. The reason for thisbeing the misuse of derivatives. The volatility of the factors thatinfluence the value of derivatives and fluctuations make theinvestments risky. Deutsche is over-leveraged by these derivatives byhaving more than half of its Tier 1 assets as derivatives. These mayget investors disturbed by Brexit and the European political climatewhich has become unstable there is the need to save the bank fromthe factors that may make them collapse (United States, 2011).
Theuse of derivatives in Qatar
TheQatar Stock Exchange was previously known as the Doha SecuritiesExchange it was established in 1995. It changed its name to QatarStock Exchange in 2008. The stock exchange has made some milestonesin infrastructural development. This includes the projected roll-outof the new IMEX energy derivatives exchange in Qatar. The QatarFinancial Center Regulatory Authority has approved the tradingplatform which is being run and organized by the InternationalMercantile Exchange Holdings which is seeking regulation and approvalof the Qatar Financial Center Regulatory Exchange. Among the MiddleEast countries, Qatar has experienced the most significant growth anddevelopment of the financial market. The trading platform providesenergy futures, swaps, and options trading especially with thebooming energy business in most of the oil-producing countries in theMiddle East (Ismath & Mirakhor, 2013).
Theuse of use derivatives in the MENA region
TheMiddle East has a larger energy reserve thus making such tradingplatform become profitable despite the fact that most opportunitiesfor derivative business are dominated by the Western countries. Thewhole of Middle East region would benefit from this initiative due toits great financial development. Rolling out of financial platformfor derivatives wouldenable the hydrocarbon products to gain more leverage in theinternational market, and the presence of a well-structuredderivative market would shield the investors and producers from risksthat exist in the volatile energy sector (Ismath & Mirakhor,2013).
Thereare no other derivative markets in the other Middle East Countries.The political instability and uncertainty in most of the MENAcountries make it very hard for the financial market to grow and runsmoothly. Qatar would be the first to roll out an actual futurestrading platform, and this would go a long way in improving themarket since the Middle East and Northern African countries holdalmost 60% of the world`s largest oil reserves. Even though the useof future contract and other derivatives has proven to becatastrophic if not properly managed they are still the best way ofhedging the inherent financial risks that every investor faces.
Anumber of markets have faced some challenges in the past due to theuse of derivatives. However, financial markets in the developingcountries in Africa and Asia should not shy away from using thederivatives for the purpose of growing their economies. Governmentsand regulatory bodies should provide the infrastructure required toeffectively deal with these transactions which occur on a dailybasis. The markets should be efficient enough to ensure that both thebuyers and sellers of such securities have the proper information toenable them to make the right decisions on how to invest their money.Qatar has grown to be an energy hub with the potential to beat worldleaders due to the fast growth of the industrial sector as well thetechnological advancements. Financial innovations are needed tothrust the economy to its full potential. Qatar is therefore on theright path to greatness and if all Middle East countries followedsuit they would not have the many instances of political unrests andterrorism that is dragging them down. In order to ensure totalindependence of their oil market, Qatar would benefit a lot from thedevelopment of IBEX platform in its financial center located in Doha.
InHirsa, A., & In Neftci, S. N. (2014). Anintroduction to the mathematics of financial derivatives.
Ismath, B. O.,& Mirakhor, A. (2013). IslamicCapital Markets: A Comparative Approach.Somerset: Wiley.
UnitedStates. (2011). Thefinancial crisis inquiry report: Final report of the NationalCommission on the Causes of the Financial and Economic Crisis in theUnited States.Washington, DC: Financial Crisis Inquiry Commission.