Derivatives: Benefits, Risks, and Regulations

This paper explores much preexisting research and history about derivatives. Derivative contracts can be used to hedge risk and to speculate in markets. To find the affects of hedging and speculating, I explored what other researches had found in studies and documented in history. Through out history, the regulations of derivatives have changes. I further explore some of the most recent changes in legislation and included those changes and some of the affects in this paper. Based upon the research of others I find that when non-financial firms hedge, those firms receive a lower cost of equity and cost of debt than firms that do not hedge. Firms that use derivatives also can experience savings in tax liabilities. Many studies find that non-financial firms that hedge experience a higher firm valuation than firms that did not hedge. However, there were a few studies that did not find any significant affect on firm value from derivative usage. By reading research, books, and other historical information on the Tulipmania, South Sea Company, and Subprime Mortgage Crisis, I find that speculation increases risk. Price risk, liquidity risk, counterparty risk, and systemic risk are some examples of risk that increases when derivative users speculate. When the markets took a turn in each of these historical examples speculators realized these increased risks. I also find that deregulation of industries including the financial industry is part of the reason why derivatives began growing so much around the 1970’s in the United States. Regulators tried to regulate swap contracts, but they ended up backing off when dealers moved overseas. The lack of investor protections and regulations of swaps hurt investors during subprime mortgage crises. After the crises, countries with major economies and emerging economies came together to increase regulations on derivatives. I conclude that hedging with derivatives is beneficial for firms and can allow firms to increase firm value in different ways, and that speculation increases risk. Even though speculation increases risk, these risks may not be as severe in the future now that countries are coming together to regulate derivatives.