Some inhibiting factors that affect the derivative instruments

Though derivatives are very useful for managing various risks, there are certain inhibiting factors which stand in their way. They are as follows:

(i.) Misconception of Derivatives:

There is a wrong feeling that derivatives would bring in financial collapse. There is an enormous negative publicity in the wake of a few incidents of financial misadventure. For instance, Barings had its entire net worth wiped out as a result of its trading and options writing on the Nikkie index futures. There are some other similar incidents like this. To quote a few: Procter and Gamble, Indah Kiat, Showa Shell etc. However it must be understood that derivatives are not the root cause for all these troubles. Derivatives themselves cannot cause such mishaps. But, the improper handling of these instruments is the main cause for this and one can not simply blame derivatives for all these mishappenings.

(ii.) Leveraging:

One the important characteristic features of derivatives is that they lend themselves to leveraging. That is, they are ‘high risk — high reward vehicles’. There is a prospect of either high return or huge loss in all derivative instruments. So, there is a feeling that only a few can play this game. There is no doubt that derivatives create leverage and leverage creates increased risk or return. At the same time, one should keep in mind that the very same derivatives, if properly handled, could be used as an efficient tool to minimise risk.

(iii.) Off Balance Sheet Items:

Invariably, derivatives are off balance sheet items. For instance, swap agreements for substituting fixed rate interest bearing asset by floating rate bonds or for substituting fixed rate interest bearing asset by floating rate interest paying liability. Hence, accountants, regulators and others look down upon derivatives.

(iv.) Absence of Proper Accounting System:

To achieve the desired results, derivatives must be strongly supported by proper accounting systems, efficient internal control and strict supervision. Unfortunately, they are all at infancy level as far as derivatives are concerned.

(v.) Inbuilt Speculative Mechanism:

In fact all derivatives contracts are structured basically on the basis of the future price movements over which the speculators have an upper hand. Indirectly, derivatives make one accept the fact that speculation is beneficial. It may not be so always. Thus, derivatives possess an inbuilt speculative mechanism.

(vi.) Absence of Proper Infrastructure:

An imported requirement for using derivative instrument like options, futures, etc. is the existence of proper infrastructure. Hence, the institutional infrastructure has to be developed. There has to be effective surveillance, price dissemination and regulation of derivative transactions. The terms of the derivative contracts have to be uniform and standardised.

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