Use and Abuse of Financial Instruments

On January 28, 2000, the London Financial Times ran an article entitled "Entry Fee Starts at $20 bn" that began "Banks are doing very nicely from the explosive growth of the derivatives markets in all its forms. Although competition is fierce, some 10 to 20 banks are emerging as the powerhouses driving the industry worldwide" ("Entry Fee," 2000). By best estimates, companies and banks around the world are involved in some 52 trillion dollars (US) worth of financial derivatives (Geer, 1997, 52). Financial derivatives, as will be explained later in this paper, are financial transactions that multinational companies engage in to protect their investments in foreign countries.

In December, 1999, the semiannual market report issued by the International Swaps and Derivatives Association (ISDA) revealed that worldwide growth in the use of privately negotiated derivatives (measured by using the notional principal of outstanding transactions) slowed to 3.4% in the first half of 1999. In derivatives accounting, the notional amount is used to measure volume but not risk, and that amount was $52.711 trillion at June 30, 1999. That figure had grown from $50.997 trillion six months earlier and $36.974 trillion one year earlier.

"The slowdown reflects the return of credit and currency stability from the exceptional volatilities associated with the Asian crisis, the Russian bond default and other events in th

. . .
t (albeit one with unknown or unconceived Beta) and that instrument can then be "traded" or "swapped." In the "swaps" market, as in the "derivatives" market, all that is being done is two trades are being combined, exchanging one currency for another at a certain date, usually spot, and reversing this transaction at a predefined date in the future. The major economic function of derivatives is typically seen in risk sharing, since derivatives provide a more efficient allocation of economic risks (Adler & Prasad, 1992, 112). An exporter, for example, can hedge his receipts in foreign currency with currency put options, or by selling currency forward or futures contracts. A portfolio manager hedges the overall stock market exposure by selling index futures contracts. How Are the Risks Calculated? Moving from the theoretical arena to the practical arena, it is instructive to see how one company used the concept of derivatives to insure against future losses. The company is Procter & Gamble, and the year is 1990. P & G's accounting members and Board of Directors wanted to reduce the money it was losing on interest rate exposure. Following the trend of the times, they utilized derivatives swaps to covert some fixed
. . .

Some common words found in the essay are:
Arthur Anderson, Board Directors, Association ISDA, Derivatives Derivative, Amihud Mendelsohn, Procter Gamble, Management Research, JP Morgan, Forward FX, Chase Manhattan, loomis 1995, exchange rate, commercial paper, basis below commercial, treasury rates, fixed rate, iskandar 1997, below commercial, 75 basis, risk sharing, rate swaps, 75 basis below, entry fee starts, senate banking housing, fee starts $20,
Approximate Word count = 2167
Approximate Pages = 9 (250 words per page)

More Essays on Use and Abuse of Financial Instruments