Question

Derivatives have become common place in large national banks. They can be very useful, but also quite complicated. A major cause of the housing crisis can be tied back to derivatives. Research and describe one type of derivative you think would be useful to a financial institution. Describe that derivative and how it would be useful.

Answer 1

Derivatives are financial instruments which have derived their value on some underlying assets. These are complicated financial assets and many investors do not have proper knowledge about how these financial instruments should be traded. The housing crisis in U.S. was due to one such type of financial derivative i.e. swaps. However, there are other types of derivatives also like futures contracts, forward contracts and options contract. I believe among the different types of derivatives, the Futures contracts are the most suitable for a financial institution. This is because these contracts are traded in organized exchanges and there is daily settlement. This will help in regulating the transactions that take place between the buyers and sellers. Due to the regulation, there are less chances of any financial crisis or frauds to take place. The advantage of investing in future contracts is that they help to transfer the risk from one party to another and also earn more profits.