Executive Summary
This paper will define derivatives as well as give different types of derivatives contracts. The important of these derivatives to the investors will be underlined. The case of the Indymac bank will be highlighted as well as reasons that led to its collapse discussed. A conclusion on the most important issues on the paper will also be given.
Introduction
A financial instrument that usually has value that is extensively based on movements of price of assets which is expected in future forms the definition of a derivative. It is worth noting that a derivative is an alternative investment which is mostly practiced by most banks, hedge funds and other financial institutions dealing with all forms of mortgages. Derivative has not tangible value on its own although they are usually traded in the markets and especially stock markets as if they are some forms of assets (Whaley, 2006.p3).
Functions of Derivatives
Mainly, derivatives are used by the investors to provide influence or power that causes a huge difference in the derivative value. They are also used as a profit making tool especially when the value of the assets presented in the trade moves in the way which the investors want it to move. In addition, derivatives also prevent risks in underlying asset as well as create a conducive environment and event which favors the trading of the underlying asset. The derivatives are also used by the investors to form an option to the trading of the underlying. In most cases, they provide the specific price level reached by the underlying which is usually made possible by the derivatives (Chance.2010.p2).
It is worth noting that derivatives provide a form of risk mitigation. They allow for transferring of price related risks from the underlying asset between the parties involved in any financial transaction. In most cases, derivatives are insured due to uncertainties of availability of assets as well as that of price changes. The risks involved in derivatives is reduced through signing of contacts which ensures that one party becomes a risk taker of one risk type while the other party becomes a risk taker for another form of risk ( Peebles, 2010.p3).
In banks that offer mortgages as well as mortgage companies, the institutions acquires risk of losing supplementary income while the individual who gain assets through mortgages or loans acquires the risk of having to pay extra money in future than he could have actually paid at that specific time. This process of attaining and at the same time evade risks is usually referred to as hedging. Hedging also allows for individuals as well as institutions which buy chattels such as products, stock and bonds with the aim of selling them by means of prospect contracts to have the advantage of holding the commodity thereby mitigating the risk of deviating selling price in future (Mladjenovic, 2006.p290).
Notably derivatives serve the purpose of a legitimate business transaction since it helps in reducing doubts concerning steady earnings as well as interest rate rise. Individuals and institutions usually sign derivative contacts in order to hypothesize on the underlying asset worth. The parties are also involved in betting on the prospect value of underlying products. In most occurrences, speculators always want to purchase assets at a much lower price in accordance with the derivative contract especially when the prospect price is high. Consequently, the speculators would also want to sell a commodity at a much higher price in accordance with derivative agreement when the prospect price is low.
Types of Derivatives
The derivatives contracts which are traded in the markets are two in number and they are differentiated through the ways in which they are traded in the markets. These two groups include (OTC), over the counter derivatives, which are conferred privately but directly between the parties involved. The two parties do not go through intermediaries. However, among the products transacted through the OTC derivatives are exotic options, swaps and forward rate agreements. It is worth noting that the OTC derivatives forms the biggest markets for derivatives since it is usually unregulated owing to the fact that the market is largely composed of banks and other parts which include hedge funds. The transactions involved in OTC derivatives are hard to report since the negotiation is done in private. The OTC derivatives are not operated on an intermediary thereby engaging the parties involved to counter party threat (Hunt, 2004.p25).
Exchange traded derivative contracts (ETD) forms the second form of the other type of derivative contract. Notably, in ETD the transactions are usually traded through particular derivatives intermediaries or exchanges. In this type of derivative contract, individuals or institutions trade through consistent contracts that are particularly defined by the intermediary or the exchange. In most situations, the exchange acts as a guarantor to the two parties. The transactions in ETD derivatives are done in public therefore providing the financiers with access to threat or reward (Choudhry, 2010.p197).
The risk Associated with Derivatives
It is worth noting that derivatives are a form of gambling. When they go wrong, the company or institution falls and they actually lead to business close down especially when the firm is unable to raise enough capital to keep the business running. Through derivatives, the banks are able to place bets which are mainly based on leverage (Krehm, 2005.p251). The derivatives make the banks as well as mortgage brokers firms to realize the importance of applicants of loans who becomes the esteemed customers of these institutions. Usually, the risks characterized by the loan borrowers put the banks in a good position where they charge very high interest loans as well as fees and later trade the loans to other unsuspecting institutions (Purnanandam, 2007,p.24).
The case of Indymac Bank
However, in most financial situations which deal with derivatives, the risk is usually low while their reward or yield is absolutely high. This was the case with what was the seventh largest mortgage originator in the United States. In the first year of trading in derivates, the bank was receiving substantial rewards from their mortgage customers. As illustrated in the diagram, the Indymac bank was doing fine in the derivatives trade in the stock market. Notably, from the year 1998 up to 2007, the bank performance in the stock market was growing steadily. However, from the year 2007, the bank performance declined and it actually become worse in the year 2008 thereby leading to the collapse of the institution. Conspicuously, from the 1998 to 2007, the rewards to the bank were high and they reached a climax in 2007 due to high rates charged on derivatives. The bank was getting massive additional income from its borrowers. However, from the year 2007, the risk became higher to the bank thereby reducing the reward. These caused the bank to slow down since it lacked enough resources to finance its activities due to threat posed by the derivatives ( Peebles, 2010,p.18).
A Look at Bank Failures; Backstop With FDIC retrieved from http://seekingalpha.com/article/85062-a-look-at-bank-failures-backstop-with-fdic
The derivative bets required a huge amount of leverage which subsequently became huge to the borrowers who later became unable to pay off there debts thereby leading the bank into a risk of losing additionally income and in most cases the initial equity rendered by the bank to the customers. As seen in the diagram, the bank initially enjoyed good leverage over the first years. In most cases, the derivative bets are usually based on the rating of credit. A stronger or a higher rating goes along with the less the amount of derivate bet. Similarly, when the rating of the credit was downgraded, the bank was required to raise more money so as to cover the derivate bet. Due to this, the bank was required to put on sale a lot of investments and stocks between the year 2007 and 2008 as represented in the diagram. The bank deposited most of its stocks and investments at a much lower price which could not meet the required capital to put the bank on its toes (Kristof, 2008,p. 22).
This downgrade caused the bank to fail to raise enough capital to make its operations possible. The bank credit crisis left its depositors worried thereby making them to withdraw their investments and savings from the bank. The subsequent defaults have been predictable and they were concealed prospect caused by loaning measures which the borrowers had to strive hard in order to afford. Both the borrowers and the bank participated fully since they had accepted the risk associated with the derivatives contracts they engaged in. Notably, the risks caused the meltdown of Subprime mortgages provided by the Indymac bank (Kristof, 2008,p.12).
Conclusion
Derivatives are crucial as they provide enormous profits to banks, hedge funds as well as mortgage firms. However, there are two different types of derivatives contracts which include ETD and OTC. The higher the leverage the lenders have on the derivative bet, the higher the rate of interest therefore a greater reward to the institution. Conversely, if these derivatives are not employed carefully, they can actually lead to a business collapse. This is because the firm will not be in a position to raise enough capital to remain in operation as it was highlighted in the case of Indymac bank. It is therefore evident that, derivatives generates massive added income to banks, hedge funds and other institutions offering mortgages but once they go wrong, they lead to enormous losses to the firms.
References
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