Reference no: EM132902782

1. Derivatives are financial securities that derive their value from an underlying asset or group of assets. An example of a derivative is a forward contract. This type of financial security creates an agreement between two parties to exchange a specified amount of currency at a specified exchange rate on a specified future date. Future contracts are another example of a derivative security where a contracts is made specifying that a specific volume of a type of currency is to be exchanged on a specified date. Derivatives can be traded over the counter or on an exchange, but OTC trades are what dominates derivative trading. Derivatives trading is often used to speculate future exchange rate movements subsequently hedging their exposure to exchange rate risk.

The risk in speculators using dangerous derivative products lies in the lack of proper regulations in OTC derivative trading. Such trading taking place on an exchange must adhere to established regulations and derivatives are standardized, meaning it is cleared and settled by an approved clearing house. Along with this, OTC derivative trading creates a greater possibility of counter-party risk as they are unregulated and involve a private transaction. Such an instance occurs when one party in the agreement defaults on the contract.

The problem with speculative trading during the 2008 financial crisis was a lack of oversight and regulation. The Dodd Frank act signed in 2010 had two sections concerning derivatives trading and the regulations surrounding them; Titles VII and XVI. Title VII dealt with valuation and taxation methods while Title XVI specifies which derivatives are exempt from "treatment as § 1256 contracts for taxation purposes.3" Speculators should be allowed to trade in complex derivative products as protections are in place for fraud and other associated risks. It is important to continuously revise and add to the regulations in place to ensure an even playing field down the road.

2. Derivatives is a financial security that has a value that relies on an asset or collectively groups of assets and prices of derivatives rely on the price of these assets. If these assets' price fluctuates, it can affect the price of the derivative. These assets can be stocks, bonds, commodities, currencies, interest rates, and market indexes which can be purchased through brokerages. When currency derivatives are used to speculate on complex and potentially dangerous derivative products, the investor does not need to have a holding or portfolio for the underlying asset. It can be extremely risky to use currency derivatives because it uses the prices of an underlying asset, which can fluctuate and are subjected to supply and demand.

In currency derivatives, these options and contracts are used to hedge against currency fluctuations by exchanging currency for another stated in the contract at specified date. This can be helpful for businesses who are trading with foreign countries to hedge their future payables and receivables. Speculators can use currency derivatives to profit on the future exchange of currency and make gains from the shifting exchange rate. Speculators are able to access derivatives and are seen to use this as a way to to do option trading nowadays. It involves a high level of risk because derivatives don't hold a value of their own but relies on another asset and one party can default. I believe that before engaging in any derivatives, people should know the risks associated and realize that it can become volatile . Much like the mortgage derivatives in the global financial crisis, people weren't informed about what the underlying assets are. Once mortgages were defaulted, the derivatives automatically were worthless and people lost everything as a result of the bubble.