Notion of Derivatives Essay examples

Notion of Derivatives Essay examples

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In the 2002 Berkshire Hathaway annual report, Warren Buffett details how it is that both the discrete and macroeconomic risks of derivative instruments pose a serious threat to the greater financial stakeholder. However, Buffet admits that his firm does use large derivative transactions to facilitate the management of its equity transactions, citing the micro-transactional benefit that can be realized by a party that is able to shift its risks to the financial market. With such a distinction in mind, this paper intends on developing how it is that the risks of derivatives are used in the global financial system to offset discrete financial risks, while replacing them with compounding counter-party risks, as mentioned by Mr. Buffet.
The main argument of Buffet(2002) is that derivative instruments magnify counter-party risks through the way in which they are generally distributed on margin, and without collateralization, a claim supported by Bodie et al(2011), and then redistributed throughout the markets in a way which will “...also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counterparties tend to build up over time”(Buffet,2002:15). Buffet(2002) illustrates how it is that this linkage effect has resulted in a situation where a large amount of derivatives risk has been concentrated within a small quantity of dealers, meaning that the capitulation of a single dealer will result in the systemic default of the entire derivative industry. Specifically, OCC(2011) describes how it is that only four institutions control $249 trillion worth of derivatives contracts. This means that American derivatives exposure ...


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...012). Interestingly enough, Warren Buffet maintains a sizable position in Suncor, and must obviously see benefit to their use of derivatives contracts to reduce the pricing risks of their continuing operations(Stempel&Lopez,2013).
Based on the culmination of research covered in this report, the conclusions of Buffet(2002) can be placed into contexts. Specifically, despite the way in which the concentration and volume of derivatives securities traded present a serious risk to the global financial system as a whole, the actual risk presented is bound by the ability of contract parties to settle out their contracts through the offsetting of outstanding positions. While a systemic unwinding of the derivatives markets through settlement would indeed be painful, it would not likely represent as large a risk as its nominal profile suggests do to their offsetting positions.

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