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Cocheo (1993) Advises That Derivatives Are Also Sometimes Termed ‘notionals', ...

Cocheo (1993) advises that derivatives are also sometimes termed ‘notionals', and that there is a concern that they hold the potential of being the next financial crisis as a result of systematic risk.
That idea stems from the proposition of ‘systematic risk' which the Bank for International Settlements in 1992 defined as The risk that a disruption (at a firm, in a market segment, to a settlement system, etc.) causes widespread difficulties at other firms, in other market segments or in the financial system" (Cocheo, 1993). Systematic risk represents the potential likelihood regarding the collapse of a financial system as in a stock market crash or in a breakdown as represented in the banking system (Duan and Wei, 2005). A lot of the concerns regarding derivatives is a result of some of these instruments being derived from other transactions such as interestrate and currency forwards; options; swaps; caps, floors, and collars; and their combinations and variations as well as related instruments (Cocheo, 1993).
And a lot of that concern has a basis in fact!
In the recent past, derivatives have provided spectacular headlines with respect to their failures. Situations as befell companies such as the Long Term Capital Management, Orange County and Baring Brothers bring to mind situations where derivatives failed - often miserably (McCarthy, 2000). The following illustrates the preceding:
Chart 1 Derivative Losses in the 1990s
(Kettel, 1999)
Company / Entity
Amount of Loss
Area of Loss

Air Products
$113,000,000
Leverage and currency swaps

Askin Securities
$600,000,000
Mortgage backed securities

Baring Brothers
$1,240,500,000
Options

Cargill (Minnetonka Fund)
$100,000,000
Mortgage derivatives

Codelco Chile
$200,000,000
Precious metals futures and forwards

Glaxo Holdings PLC
$150,000,000
Mortgage derivatives

Long Term Capital Management
$,000,000,000
Currency and interest rate derivatives

Metallgesellschaft
$1,340,000,000
Energy derivatives

Orange County
$2,000,00,000
Reverse repurchase agreements

Proctor & Gamble
$157,000,000
Leveraged German marks and U.S. dollars spread


In light of the preceding, one would reasonably expect that companies might have cut down their use of derivatives, which has not been the case. The global derivatives market grew to $270 trillion at the end of 2005, up from $98 trillion recorded in 2000, with predictions indicating that the phenomenal growth will continue (Pizzani, 2006). Growth in the derivatives market is being underpinned by Wall Street's largest brokerage companies along with commercial banks that have, and are seeing extremely significant revenues as a result of their market activities in this quarter (Pizzani, 2006).


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