Challenges of the Knowledge Society (Apr 2011)
CONTROVERSIES IN USING DERIVATIVES IN THE CONTEXT OF THE FINANCIAL CRISIS
Abstract
As a phenomenon, risk is specific for any human activity. Following this logic, we can say that this concept is a constituent element in the definition given to the financial sector, investments and market competition. The questions that the whole range of operators (governments, regulation bodies, financial institutions, companies and shareholders) must answer are: Which type of risk should one assume within an economic entity and to what extent should that risk be taken? If risk is materialized, to what extent will the financial consequences affect the involved parties? By enforcing laws that might eliminate economic risk, regulation bodies attempt to create an ideal regime in which the concept of”bankruptcy” does not exist. Thus, financial institutions and companies which hold a key position in the different economic sectors are prevented from performing actions that might lead to their bankruptcy. The positive effects of the regulation are doubled by less appreciated effects, such as the limitation of the investment potential. Working in this environment, the financial and economic agents’ behaviour has significantly modified, i.e. it has mitigated the degree of risk aversion. The solution for this is establishing more flexible regulation lines that do not have as a main objective the elimination of failure, but rather the reduction of frequency with which such incidents occur and to manage the individual investors’/consumers’ losses. One must preserve a balance between the need for facilitating risk internalization and the efficient use of capital (a fundamental operation for maintaining competitiveness and innovation spirit), on the one hand, and maintaining a certain protection level for the investor/client, on the other hand. For regulation bodies any of the two options will be a priority, since it is obviously in the commercial interest of any company (and, certainly, of the suppliers, customers and associates) to efficiently manage risks that derive from its activity and, for this purpose, to take into consideration the use of derivatives. Recent financial collapses have illustrated the consequences generated by the improper application of the basic risk management principles and of the efficient implementation strategies for derivatives.
