Saturday, August 18, 2012

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text courtesy of Wikepedia
According to Raghuram Rajan, a former chief economist of the International Monetary Fund (IMF), "... it may well be that the managers of these firms [investment funds] have figured out the correlations between the various instruments they hold and believe they are hedged. Yet as Chan and others (2005) point out, the lessons of summer 1998 following the default on Russian government debt is that correlations that are zero or negative in normal times can turn overnight to one — a phenomenon they term “phase lock-in.” A hedged position can become unhedged at the worst times, inflicting substantial losses on those who mistakenly believe they are protected."[23]
[edit] RiskSee also: List of trading losses
The use of derivatives can result in large losses because of the use of leverage, or borrowing. Derivatives allow investors to earn large returns from small movements in the underlying asset's price. However, investors could lose large amounts if the price of the underlying moves against them significantly. There have been several instances of massive losses in derivative markets, such as the following:
American International Group (AIG) lost more than US$18 billion through a subsidiary over the preceding three quarters on Credit Default Swaps (CDS).[24] The US federal government then gave the company US$85 billion in an attempt to stabilize the economy before an imminent stock market crash. It was reported that the gifting of money,which came to be known as the "Back door bailout" of America's largest trading firms, was necessary because over the next few quarters the company was likely to lose more money.
The loss of US$7.2 Billion by Société Générale in January 2008 through mis-use of futures contracts.
The loss of US$6.4 billion in the failed fund Amaranth Advisors, which was long natural gas in September 2006 when the price plummeted.
The loss of US$4.6 billion in the failed fund Long-Term Capital Management in 1998.
The loss of US$1.3 billion equivalent in oil derivatives in 1993 and 1994 by Metallgesellschaft AG.[25]
The loss of US$1.2 billion equivalent in equity derivatives in 1995 by Barings Bank.[26]
UBS AG, Switzerland’s biggest bank, suffered a $2 billion loss through unauthorized trading discovered in September, 2011.[27]
This comes to a staggering $39.5 billion, the majority in the last decade after the Commodity Futures Modernization Act of 2000 was passed.
[edit] Counter party riskSome derivatives (especially swaps) expose investors to counter party risk, or risk arising from the other party in a financial transaction. Different types of derivatives have different levels of counter party risk. For example, standardized stock options by law require the party at risk to have a certain amount deposited with the exchange, showing that they can pay for any losses; banks that help businesses swap variable for fixed rates on loans may do credit checks on both parties. However, in private agreements between two companies, for example, there may not be benchmarks for performing due diligence and risk analysis.