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2 Billion In Profits As A Result Of Their Derivatives Business, In Some Cases ...

2 billion in profits as a result of their derivatives business, in some cases accounting for between 8 and 10 percent of their overall revenues (Pizzani, 2006).
And this rampant rush for profits is what has a number of quarters concerned! Tett (2006) reports in an article written for the Australian, that three of the world's most powerful financial regulators have issued a joint warning that individual nations cannot contain some of the risks represented by the growth of derivatives. They point to the failure of hedge fund Amaranth that lost $6 billion in U.S. gas markets during 2006 (Tett, 2006). The preceding predictions have also been repeated with warnings of a derivatives bubble as a result of the unimpeded growth the market has been experiencing (Ruppert, 2001). However, that prediction was made in 2001, and the derivatives market has exploded since that time. Derivatives are traded on both organized exchanges, and over-the counter (OTC) markets (with) an example of an OTC transaction is a contract offered by a bank or a securities firm that can be tailored to the needs of the user (Solomon, 1999, p. 111).
In a speech conducted at the New York University Stern School of Business on 16 May 2006 by Timothy F. Geithner, the president and chief executive officer of the Federal Reserve Bank of New York, he stated that Credit derivatives have contributed to dramatic changes in the process of credit intermediation, and the benefits of these changes seem compelling (Federal Reserve Bank of New York, 2006). Geithner advised that credit derivatives have made substantial improvements in the manner of how credit risk is managed, and has aided in facilitating a broad distribution of that risk outside of the banking system (Federal Reserve Bank of New York, 2006). The preceding has aided in a broader spreading of credit risk whereby shocks are diffused as a result of a broad spread, as opposed to concentration (Federal Reserve Bank of New York, 2006).
Credit derivatives represent a contract to take the risk in the total return on the potential a credit asset might fall lower than the agreed level, and transfer it, without transferring the asset (Vaillant, 2001). The aforementioned is accomplished by transference of the risk on what is termed a credit reference asset (Vaillant, 2001). Credit derivatives come in many forms, with the most common known as follows (Moneyscience, 2007):
Credit Default Swap
This represents a ‘swap' that is designed to transfer the credit exposure related to fixed income products. A credit default swap represents the most broadly utilized type of credit derivative. Briefly, it consists of an agreement consisting of the protection buyer, and the protection seller, with the buyer paying a periodic fee for the consideration of a contingent payment on the part of the seller in the instance of a credit event as evidenced by an example of a default of some type.


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