Posted: February 25th, 2021
Currency derivatives are very useful to global financial managers to hedge FX risk, but they can also be used by speculators. Should these speculators be able to use complex and potentially dangerous derivative products? (Recall the roll of complex mortgage derivatives in the global financial crisis of 2008)
Currency derivatives are described as those contracts that have exchange-based futures as well as options which allow one to hedge against currency movements. Because of their nature of interrupting the financial flow in the system as they can increase the efficiency of the financial market but when they are not utilized well they can cause a financial crisis (Singla & Luby 2020). Basing on the 2008 financial crisis, it was discovered that the main cause for this crisis was proliferation of unregulated derivatives where these complicated financial values could tend to make an underlying index as the main values. Therefore the speculators need to use these currency derivatives in their simple forms that can be analyzed and controlled but the complex and potentially dangerous derivative products should be avoided.
It is worth noting that some of the borrowers in the 2008 financial crisis utilized the interest-only type of loans which can be categorized as the adjustable-rate mortgage where the interest rates rose along with the fed funds rate. However the challenge came in when the mortgage-holders realized that they could not afford the payments any further as a result of the increase in the fed fund rates. This case led to a decrease in the demand for the houses since these people could not afford (Hsiao & Tsai 2018). Because of the rise in the number of loan defaulters from the members who borrowed money to build houses but no more tenants means the banks and hedge funds had many derivatives that were declining in value as well they could not sell them. According to the findings in the global financial crisis 2008, the speculators should cease from using complex mortgage derivatives products based on the experience obtained where the banks could even come the diminish. Failure to release derivatives means there are no transactions going on to enable the bank get some interests.
Currency derivatives are great, especially when the rate is expected to increase to lock in a price in the moment. Speculators are also able to buy and sell these products, which they will take advantage of especially if they expect an increase because they can then sell it for more later.
The issue arises when there’s no oversight or regulation in this market, the same way there wasn’t any in the 2008 financial crash.
In fact, this Bloomberg article describes it perfectly when they mention ” The folly of this approach became apparent when, in the darkest days of the 2008 crisis, it emerged that a single company — insurance giant AIG — owed billions on subprime-mortgage bets to several of the world’s largest banks and didn’t have the cash to pay up. Taxpayers had to provide $182 billion to keep the company afloat and avert a broader collapse.” Then, of course, it’s the taxpayers which have to step up to pay for the shortfalls of unregulated and risky “investing,” as there’s a big wager with little money backing it. While mortgages were a good and practically risk-free investment, it was the lack of regulation and greed that messed everything up.
I feel the same thing can happen with currency derivatives without a regulated market since “the derivative itself has no intrinsic value—its value comes only from the underlying asset—it is vulnerable to market sentiment and market risk. It is possible for supply and demand factors to cause a derivative’s price and its liquidity to rise and fall, regardless of what is happening with the price of the underlying asset.”
Derivatives are financial securities that derive their value from an underlying asset or group of assets. An example of a derivative is a forward contract. This type of financial security creates an agreement between two parties to exchange a specified amount of currency at a specified exchange rate on a specified future date. Future contracts are another example of a derivative security where a contracts is made specifying that a specific volume of a type of currency is to be exchanged on a specified date. Derivatives can be traded over the counter or on an exchange, but OTC trades are what dominates derivative trading. Derivatives trading is often used to speculate future exchange rate movements subsequently hedging their exposure to exchange rate risk.
The risk in speculators using dangerous derivative products lies in the lack of proper regulations in OTC derivative trading. Such trading taking place on an exchange must adhere to established regulations and derivatives are standardized, meaning it is cleared and settled by an approved clearing house. Along with this, OTC derivative trading creates a greater possibility of counter-party risk as they are unregulated and involve a private transaction. Such an instance occurs when one party in the agreement defaults on the contract.
The problem with speculative trading during the 2008 financial crisis was a lack of oversight and regulation. The Dodd Frank act signed in 2010 had two sections concerning derivatives trading and the regulations surrounding them; Titles VII and XVI. Title VII dealt with valuation and taxation methods while Title XVI specifies which derivatives are exempt from “treatment as § 1256 contracts for taxation purposes.3” Speculators should be allowed to trade in complex derivative products as protections are in place for fraud and other associated risks. It is important to continuously revise and add to the regulations in place to ensure an even playing field down the road.
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