MSG Team's other articles

12362 The Argentine Currency Crisis

The Argentine economy is no stranger to economic crises. The country saw a massive financial crisis with the currency almost collapsing in the year 2001. Now, seventeen years later, Argentina seems to be back to square one. Once again, the inflation rates in this Latin American nation have started skyrocketing. Also, the declining value of […]

12616 The Capability Maturity Models and their Usefulness for Organizations

Capability Maturity Models When organizations want to be certified for their quality or operational excellence, they usually turn to quality frameworks like Six Sigma, Kaizen, or TQM. These are just representative of the different quality and operational excellence models and there are many other frameworks as well. Similarly, there are process capability models like the […]

9881 Import Documentation Requirement for Customs Clearance

In effecting Imports as well as Exports, documentation plays a very important role. Especially in case of imports, the availability of right documents, the correctness of the information available in the documents as well as the timeliness in submitting the documents and filing the necessary applications for the Customs Clearance determines the efficiency of the […]

12080 Developing the Predictive Equation

Once the Scatter plot has been used to find out the correlation between the inputs being measured as well as the desired outputs, it is now time to come up with an equation which shows the precise relationship. This is called Regression. Regression is a technique which summarizes the relationships observed in the Scatter plot […]

12548 Business Analytics – Meaning, Importance and its Scope

Introduction The word analytics has come into the foreground in last decade or so. The proliferation of the internet and information technology has made analytics very relevant in the current age. Analytics is a field which combines data, information technology, statistical analysis, quantitative methods and computer-based models into one. This all are combined to provide […]

Search with tags

  • No tags available.

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.

Financial Crisis

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.

Article Written by

MSG Team

An insightful writer passionate about sharing expertise, trends, and tips, dedicated to inspiring and informing readers through engaging and thoughtful content.

Leave a reply

Your email address will not be published. Required fields are marked *

Related Articles