Treasury and Risk Management Financial Crises

Question: Discuss about theTreasury and Risk Management for Financial Crises. Answer: Introduction: The overall assignment mainly focuses on the role played by derivatives in the 2007 financial crises. In addition, the study evaluates how financial crisis negatively affected the financial market of world economy. Further explanation is been provided whether the crisis would occur again in future. Relative derivatives that is been used by the investors and financial institutions for conducting trade post, during and pre 2007 world crisis. Majority of the financial analyst mainly describes the meltdown of 2007 financial crisis, as the devil casino where investors dealt in debt derivate structure. The CDOs were mainly used as the major derivate option, which resulted in augmentation of financial crisis. Explain the Role of Derivatives in the 2007 Financial Crises: Before the augmentation of the financial crisis, the overall derivative market allowed banks to transfer their mortgage-backed security to investors. The derivatives market mainly allowed the banks to raise capital by selling the mortgage-backed securities (Adebambo, Brockman and Yan 2015). The process used by the banks in distributing the loans to relative hedge funds is depicted as follows. Firstly the banks lend money to the individuals for buying homes Secondly the bank sold the mortgage to Fannie Mae, which allowed banks with additional cash to make new loans Furthermore, the asset-backed mortgage bought by Fannie Mae is resold in the secondary market under name of Mortgage-backed-security (MBS). The overall value of the security is mainly derived from the mortgage bundle. Lastly, the MBS is mainly bought by hedge fund, which then divides the security and only retains low risk investment. The left out securities are then included in new derivatives instrument and sold to other hedge funds. This reselling process is mainly of just a portion of the fund is mainly known as tranche. The overall trading of mortgages was conducted with the help of derivatives, which valued the security based on their underlying asset. However, each financial institutions and hedge fund companies accumulated a large number of mortgage-backed derivatives. Moreover, Warren Buffet mainly labelled the derivatives as financial weapons of mass destruction, which empowered hedge fund managers to accumulate higher debt. Chodorow-Reich (2014) mentioned that credit default swap was mainly conducted to reduce the negative impact on loss occurred from debt. On the other hand, Floyd, Li and Skinner (2015) criticises that increased accumulation of CDOs mainly increased debt accumulation of companies, which raises risk from investment. The derivative options like Asset-backed Commercial Paper, Call Option, Credit Default Swaps, Collateralized Debt Obligations, Commodities Futures, Futures Contract, Interest Rate Swap, Mortgage-backed Securities, Oil Price Futures, Put Option, Stock Options was used by financial institutions. These derivative assets mainly allowed the investors to increase the overall investment exposure. Reinhart (2013) mentioned that use of adequate derivatives instrument mainly allowed investors to take trade higher than the actual asset value. Furthermore, derivatives instruments like Collateral Debt Obligation (CDO) and Credit Default Swap (CDS) were the main reason behind the augmentation of 2007 financial crisis. Figure 1: Depicting the formation of Asset backed Securities (Source: Thebalance.com 2017) The above figure mainly helps in depicting the relevant formation of assets backed securities, which led to the origination of Collateral Debt Obligations (CDO). These CDOs mainly allowed the hedge fund managers to divide the MBS into different segments with risk ratings. The Asset backed Securities are mainly divided into tranches, which depicted the overall risk from investment. Furthermore, for securing the overall CDOs, Credit Default Swaps (CDS) were mainly developed, which reduced the risk from non-payments from investment. Furthermore, the complex derivative market mainly allowed the investors to expand the overall mortgage market, which its performance remained same. Reddy et al. (2014) stated that derivatives does not create or destroy the assets, it just helps in balancing the trades between two investors. The overall derivatives market was unregulated and mainly traded in OTC without the presence of a clearinghouse. This absence of clearing house mainly fails to accommodate the high risk from CDOs, which might hamper return from investment. The unregulated CDOs mainly amounted to $604.6 trillion in OTC derivatives contracts, which was ten times the world GDP. The overall CDS were purchased by investors for subprime derivatives, which helped in reducing the risk from mortgage investment. Furthermore, the extensive use of derivatives market was mainly increasing the risk for investors, as value of the underlying assets was considered. Bourkhis and Nabi (2013) mentioned that banks before the financial crisis provided home loans to everyone without adequate security for payments. Moreover, the derivative market mainly allowed banks to restructure the overall CDOs into new CDOs, which could be traded again in the secondary market. The companies are mainly able to distribute the subprime and high risky mortgage securities in new CDOs, which help in reducing the liabilities in their accounting books. Furthermore, these CDOs were again traded in the secondary market with high rating provided from credit rating agencies. As depicted in the book Fools Gold, companies were mainly able to reduce their subprime securities by creating new CDOs with wrong credit rating. This manipulation conducted by the banks was the major problems, which led to the augmentation of the financial crisis. In this context, Garcia-Appendini and Montoriol-Garriga (2013) argued that Lehman Brothers accumulated high end CDOs, which evaluated the demise during the economic crisis. Furthermore, the demises started with the defaulting of loans, which comprised 98% of the CDOs traded in the secon dary market. The high credit value provided from derivative market mainly increased ability of the investors to raise its investment capacity. Explaining Whether the Crises Could Occur Again: The current market system has been degrading due to decline in capital market during 2013 and 2015. Furthermore, the impact of 2008 financial crises is still seen in the financial market, as companies are trading new derivatives. The CDOs were changed to different derivatives, which are being used on daily basis. In addition, the bailout package used during the financial crises only pumped new money and did not reduce the negative impact of method used by financial institutions. The credit rating agencies, which rated the default CDOs are still rating the new derivative instruments, which could have high risk. Furthermore, the Chinese Banking system could be the major player in augmenting the future financial crisis, as the government controls it. This controlled market rallies conducted by the Chinese government could mainly result in inflating asset value, which was the main reason being the fall of asset market in 2008 (Nasdaq.com 2014). Furthermore, FED interest rate is still 0%, which also added to augmentation of 2007 financial crisis. Armantier et al. (2015) mentioned that he rise in FED interest rates mainly declined the ability of borrowers to pay the interest on their loans. The future rise in interest rate of FED could mainly reduce cash availability of the investors, which could initiate sell calls. In addition, the FED previously raised rate in 2006, which started the loan defaults. This accumulated default loans mainly started to liquidation of financial market. Conclusion: The above discussion mainly depicts the impact of derivative in augmenting the financial crises of 2008. In addition, the different derivatives like Credit Default Swaps (CDS) and Collateral Debt Obligations (CDO) is mainly discussed, which mainly instigated the financial crises of 2008. Furthermore, the increment in residential prices, Chinese banking system and increment in FED interest rate could lead to new future recession. These identified factors mainly increase the chances of new financial crises, which could hamper global financial market. Reference: Adebambo, B., Brockman, P. and Yan, X.S., 2015. 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