In the 2002 Berkshire Hathaway annual report, Warren Buffett details how it is that both the discrete and macroeconomic risks of derivative instruments pose a serious threat to the greater financial stakeholder. However, Buffet admits that his firm does use large derivative transactions to facilitate the management of its equity transactions, citing the micro-transactional benefit that can be realized by a party that is able to shift its risks to the financial market. With such a distinction in mind, this paper intends on developing how it is that the risks of derivatives are used in the global financial system to offset discrete financial risks, while replacing them with compounding counter-party risks, as mentioned by Mr. Buffet.
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This essentially means that it would take all of the world’s cumulative productive, inflationary, and investment capacity 3.5 years to pay off the effects of a systemic default in the derivatives markets. With that in mind, the OCC(2011) illustrates how it is that interest rate, foreign exchange and credit derivatives present the greatest nominal risk profile to the greater portfolio. Figure 1) Illustrates the net nominal credit risk associated with various derivative instrument categories (OCC, 2011).
Based on the macroeconomic risks associated with derivative instruments, it stands to reason that Buffet's(2002)’s assertion of the risks of derivatives holds true, mainly due to the way in which the counter-party risk has been magnified over time by a lack of collateralization. Elina(2009) demonstrates how it is that derivative positions can currently be used by acquiring firms to take on undisclosed control positions in an acquisition target, and are therefore in a position to abuse derivative reporting standards to avoid disclosure requirements. This again results in a situation of encouraging excessive use of derivatives, and magnifying their macroeconomic impact. That being said, the nature of the put-call-parity relationship demonstrates how it is that derivatives positions can be interchanged to offset each other(Bodie et al,2011). As such, Hwa & Lim(1994) demonstrate how it is that the process of ‘netting’ out two derivatives