This paper work will focus on four types of derivatives and analyze their characteristics and their operation for the purpose of understanding the financial crisis in 2007-2008, the credit default swaps in the financial market will be defined. The link between credit default swaps and financial crisis will also be explored. The governments’ policies in order to take control over the derivatives in financial market will be mentioned. In the conclusion part, the advantages and disadvantages of derivatives will be discussed.
Table of Contents
1 Introduction
2 Derivatives
2.1 Definition
2.2 Usage of derivative contracts in basic strategies
3 The common types of derivatives
3.1 Futures and forward
3.1.1 Basic characteristics and differences
3.1.2 Futures and forward pricing
3.1.3 Hedging, speculating using futures and forward
3.1.3.1 Hedging
3.1.3.2 Speculating
3.2 Swaps
3.2.1 Basic characteristics
3.2.2 Four basic types of swaps
3.2.2.1 Interest rate swaps
3.2.2.2 Currency swaps
3.2.2.3 Credit swaps
3.2.2.4 Commodity swaps
3.2.3 Swaps pricing
3.3 Options
3.3.1 Basic characteristics
3.3.2 Options strategies
3.3.2.1 Call option
3.3.2.2 Put option
3.3.3 Option valuation
3.3.3.1 Intrinsic and time value
3.3.3.2 Binomial option pricing
3.3.3.3 Black-Scholes valuation
4 Credit default swaps and the financial crisis 2007 - 2008
4.1 Credit default swaps on companies
4.2 Credit default swaps on subprime mortgage-backed securities
4.3 The financial crisis 2007-2008
4.3.1.1 The operation of securitization
4.3.1.2 Why did the financial crisis happen?
5 Conclusion
Research Objectives and Themes
This paper aims to define and analyze four primary types of derivative securities—forwards, options, swaps, and futures—to understand their characteristics, operational mechanics, and their pivotal role in the 2007-2008 financial crisis, specifically exploring the link between credit default swaps and market instability.
- Functional analysis of core derivative instruments (Futures, Forwards, Swaps, Options).
- Examination of risk management strategies including hedging, speculation, and arbitrage.
- Evaluation of credit default swaps (CDS) and their impact on subprime mortgage-backed securities.
- Investigation into the causes of the 2007-2008 financial crisis, including the role of securitization and monetary policy.
- Discussion of government regulatory measures and transparency requirements in derivatives markets.
Excerpt from the Book
3.1.1 Basic characteristics and difference
Futures and forwards contracts are an agreement between two counterparties to purchase or sell the underlying assets at a predetermined price at a future date. In futures and forward contracts, there are two common terms, i.e. long and short position. Adopting the long position, the buyer agrees to buy the goods in the future and has to pay seller at the delivery price, which is agreed upon today. In return, the seller who is obligated to deliver goods for the delivery price assumes “a short position”.
Forward is a private commitment between two parties and traded in OTC market. The terms and conditions are specified by the parties. That’s why forward is known as a customized contract. Because the agreement is directly negotiated by the buyer and the seller, a clearing house doesn’t exist. The underlying asset can only be purchased or sold at the day of the maturity. “These contracts are unregulated and private because the parties don't want much of the government interference in it. But it doesn't mean that there is something illegal in the contract. The contracts are private because the parties don't want to disclose much about the customized contracts”6.
In contrast, futures are a standardized contract and traded on future exchange. It is marking to market and its transaction works through the clearing house. A margin account must be created and a fixed amount of money maintained in it. Margins are divided into two types: initial and maintenance margin. At the beginning of futures, investors oblige to put a fixed value of securities in account, called initial margin. Compared to initial margin, the maintenance margin is defined as the minimum level, which assures the value of securities, is not allowed to fall below. If the value falls lower than the minimum level, investors have to make an additional payment in order to bring the account to the original value of the initial margin.
Summary of Chapters
1 Introduction: Provides an overview of derivative securities, their role in financial markets, and introduces the context of the 2007-2008 financial crisis.
2 Derivatives: Defines derivatives and explores their fundamental usage in basic investment strategies like hedging and speculation.
3 The common types of derivatives: Details the characteristics, pricing, and strategies for futures, forwards, swaps, and options, including valuation models.
4 Credit default swaps and the financial crisis 2007 - 2008: Analyzes the connection between CDS, subprime mortgages, and the structural failures leading to the 2007-2008 financial crisis.
5 Conclusion: Summarizes the dual nature of derivatives as tools for risk management versus instruments of speculation and suggests regulatory improvements.
Keywords
Derivatives, Futures, Forwards, Swaps, Options, Credit Default Swaps (CDS), Financial Crisis 2007-2008, Hedging, Speculation, Arbitrage, Securitization, Risk Management, Subprime Mortgage, Leverage, Financial Transparency.
Frequently Asked Questions
What is the primary focus of this academic work?
The work focuses on defining key derivative instruments and analyzing how their characteristics and usage contributed to the global financial crisis of 2007-2008.
What are the main financial instruments discussed in the book?
The book covers four main types of derivatives: forwards, futures, swaps, and options.
What is the core research objective?
The primary goal is to examine the operation of derivatives and demonstrate their link to the 2007-2008 financial crisis through a detailed analysis of market mechanisms and systemic risks.
What methodology does the author employ?
The author uses a descriptive and analytical approach, defining technical financial concepts and valuation models, and then applying these to historical case studies of financial market failures.
What does the main body cover?
The main body covers the definitions of derivatives, detailed strategies for each type (including valuation models like Black-Scholes and Binomial), and an examination of the role of CDS in the subprime mortgage crisis.
Which keywords best characterize this text?
Keywords include Derivatives, Financial Crisis, Credit Default Swaps, Hedging, Securitization, and Risk Management.
How does the author define the relationship between derivatives and risk?
The author presents derivatives as double-edged tools: they are effective for hedging risks but can also be used for high-risk speculation that may endanger the broader financial market system.
What explanation does the text provide for the 2007-2008 financial crisis?
The text identifies factors such as the mismanagement of securitization, the role of credit rating agencies, loose monetary policy by the FED, and the opaque use of credit default swaps on subprime mortgage securities.
What are the specific valuation models discussed for options?
The book specifically details the Binomial option pricing model and the Black-Scholes valuation model.
What recommendations does the author make for the future?
The author suggests severe evaluation of securitization processes, stricter government regulations, enhanced investor understanding of portfolios, and increased bank transparency regarding risk disclosure.
- Arbeit zitieren
- Hong Hanh Tran (Autor:in), 2013, Derivatives. Curse or Blessing?, München, GRIN Verlag, https://www.hausarbeiten.de/document/213058
