Executive Pay: The Curious Case of Carlos Ghosn’s Arrest
February 12, 2025
The world is facing a scarcity of water. Each year about 3.4 million people die due to the scarcity of water! Several million more fall sick due to the poor sanitary conditions of the water supplied. The current situation is proof of the fact that the global water supply is not being managed properly. Many […]
Introduction This article deals with the Automation project for a maintenance project in a software company. The project involves automating the processes that are discrete and disparate into a centralized monitoring mechanism via a tool developed for this purpose. This article lists the scope and the different aspects like resource and schedule planning along with […]
Socialism is a failed idea. Many nations in the world have now tried socialism. It is no surprise that all of them have failed. After the World War-2, the world was divided into two lobbies. There was the capitalist lobby led by the United States. Then, there was the socialist lobby which was led by […]
Project management is the art of managing the project and its deliverables with a view to produce finished products or service. There are many ways in which a project can be carried out and the way in which it is executed is project management. Project management includes: identifying requirements, establishing clear and achievable objectives, balancing […]
What are Mediation and Arbitration ? Mediation and Arbitration are features of the business landscape that let aggrieved parties resolve their disputes in a structured manner. In the corporate world, breach of contract, non-compliance with the terms of the agreement between companies, failure to pay or complete the work and other disputes are usually resolved […]
The previous articles in the module have discussed how the global financial crisis has been caused due to a combination of factors starting with the collapse of the housing market in the US and then due to the integration of the global economy rapidly spread to other parts of the world.
An aspect that was touched upon but not discussed in detail is the role of derivatives or the complex financial instruments used to hedge and guard against risk.
In other words, derivatives are financial instruments that are built on top of other instruments like securities, commodities and just about everything else.
Derivatives as the name implies are derived from the value of the underlying asset and hence are used to hedge against a rise or fall in the value of the underlying asset. Indeed, the global market for derivatives covers just about every asset in the world and there are even derivatives for hedging against the weather.
Since derivatives essentially are traded on the basis of the value of the underlying asset, any disproportionate fall in the value of the underlying asset would cause a crash in the derivatives designed for that purpose.
And this is what happened in the summer of 2007 when the housing market in the US started to go bust. Of course, the clever bankers had devised derivatives for such an eventuality as well and this was seen as an acceptable way of hedging risk.
So, the obvious question is that if both sides of the risk have been hedged, then there should not have been a bust in the derivative market. The answer to this is that those investment banks and hedge funds that had found the right balance between the different hedging instruments survived the crash whereas the other banks like Lehmann that were highly leveraged because of their exposure to the subprime securities market collapsed.
Of course, the above explanation is a bit simplistic since the basic problem was that the securitization of the mortgages was built on top of the plain vanilla mortgages and this coupled with excessive risk taking by derivative trading resulted in the crash of 2008.
The point here is that except for a few hedge fund traders and investment banks like JP Morgan, many banks simply were excessively leveraged which meant that the value of their liabilities far exceeded the value of the “real assets” on their books.
So, when the assets went bad, the liabilities mounted and they were left with toxic derivatives that needed bailouts from the government and write-downs to solve the problem.
Finally, as we shall discuss in subsequent articles, the absence of regulation played a major part in causing the crisis as the derivatives were traded in the OTC or the Over the Counter segment meaning that they were not subject to regulation. This meant that banks could play hard and fast with the rules and devise their own rules for derivative trading outside of the purview of the regulators.
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