International Evidence on Financial Derivatives

Question: Discuss about the International Evidence on Financial Derivatives. Answer: Introduction Financial institutions such as banks tend to face many restrictions as they run their day-to-day operations. Ideally, smaller banks tend to face many restrictions as compared to larger banks. For instance, the regulators limit the size of banks to its ability to diversify its portfolio of assets. The smaller banks are therefore restricted to little or no diversification of the portfolio of assets to protect them from negative externalities such as failure. This research paper focuses on the nature of banks, and financial risks facing financial institutions. In addition, the research focuses on asymmetric information that may be relevant in discussing the question why the regulators should not limit the size of banks to a diversified portfolio of assets despite the significant negative externalities of failures faced by large banks. Nature of Banks Classification of banks depends on its nature that is its scope, timing, and extent. Ideally, the scope of banks depends on what it is mandated to perform (Bartram, Brown, and Fehle, 2009, pp.185-206). Some banks have a diverse portfolio of assets as stipulated in their Articles of Association while others have a small portfolio of assets. Apparently, most small banks tend to be restricted to having a small or less diversified portfolio of assets. What is common in most banks whether large or small is that they are mandated to receive deposits; they are mandated to make advances regarding loans, notes, and bonds, and the effect transmission of money from one place to another (Brigham, and Houston, 2012.). The timing of banks depends on the timeframe it can offer its portfolio of assets such as loans and bonds. Smaller banks tend to have loans with a shorter period of repayment while larger banks tend to have loans or bonds with a more substantial time of repayment. The extent of bank s depends on its ability to withstand exposure to a different business line that is its exposure to risk. Financial Risks Facing Financial Institutions and Reasons why the Regulators Should Not Limit their Size Credit exposure is one factor that banks face. It is created through any form of credit in which a bank engages in (Frank, and Goyal, 2009, pp.1-37). For instance, if a financial institution gives a loan of $ 2 million to a start-up business, there will be a risk that the firm is likely to default payment. To measure credit risk, a bank must calculate its exposure to credit on its total loan portfolio about the industry. Financial risk is defined as the risk that involves financial loss to a firm. Ideally, it arises from instability in the financial markets caused by the movement in currencies, share prices, and interest rates. As the money moves from one country or part to another, the bank faces financial risks. Subsequently, stock prices are prone to financial risks since they keep on fluctuating. Banks mainly face five types of financial risks, namely: market risk, credit risk, liquidity risk, operational risk and legal risk. First, market risk is a kind of risk that arises from the movement in the prices of financial instruments such as stock prices (Froot, 2008, pp.281-294). To overcome this, banks are required to use hedging tools such as futures, forward, options and swaps. Most of these financial derivative instruments are not available to small banks and therefore these banks ought to diversify its portfolio of assets to minimize this risk. This implies that the regulators should not limit the size of banks as banks could use diversification of the portfolio of assets to reduce their market risk. Second, credit risk is a type of risk that arises when one fails to fulfill the obligation of the contract (Grable, and Roszkowski, 2008, pp.905-923). For example, if a party to a loan contract defaults payment or if he fails to pay within the designated, it will result in credit risk. If that person defaults payment, the bank would not be able to pay back the money it got from the regulators. Due to this negative externality, regulators tend to limit the size of the banks. Ideally, the larger a bank is, the better its ability to diversify its portfolio of assets. If the regulators limit its size, it will not be able to expand its portfolio of assets thus risking failure due to the credit risk. Third, liquidity risk is a type of risk that arises when a bank is unable to secure a transaction (Huang, Zhou, and Zhu, 2012, pp.193-205). For instance, if an organization requests a loan of $ 5 million, but the bank does not have enough liquid cash to satisfy its needs. The bank, in this case, will be said to be facing liquidity risk. If a bank faces this type of risk, the regulator is bound to limit its size. As a result, the financial institution will not be able to diversify its portfolio of assets. Due to this, it is more likely that the bank will encounter other types of risks that will eventually lead to its failure. This means that regulators should not limit the size of banks. Fourth, operational risk is a type of risk that is caused by operational failures of banks such as mismanagement of funds (Turner, 2014). If a bank does not have a reliable or adequate internal control system, it will likely face operational risk. Apparently, regulators will limit the size of a bank if it faces this danger since the regulators have an interest in the banks. The money that circulates in the banks is usually borrowed from the regulators. In the event, these banks will not be able to diversify thus likely to face negative externalities. To help banks prosper in the industry, regulators should not limit their size when faced with operational risk. Lastly, legal risk is a type of risk that arises out of legal constraints such as when a bank is facing a lawsuit (Walker, 2009). If a financial institution faces a legal risk, it loses trust in the eyes of the public and the regulator. The regulator then limits its size since people would prefer getting loans elsewhere. Its ability to diversify decreases, thus risking closure due to the inability to sustain in the market. Regulators should therefore not limit their size to avoid closure. Conclusion Banks are bound to face financial risks in their normal business operations. These risks include operational risk, legal risk, liquidity risk, credit risk, and market risk. If a bank faces these risks, the regulators will limit its size. A larger has a better ability to diversify its portfolio of assets. However, if the regulators reduce its size, it will be unable to diversify thus facing negative externalities. The regulators should therefore not limit the size of banks despite the negative externalities failures it tends to impose on the public, as it will risk failure. References Bartram, S.M., Brown, G.W., and Fehle, F.R., 2009. International evidence on financial derivatives usage.Financial Management,38(1), pp.185-206. Retrieved on 14 January 2017. Brigham, E.F., and Houston, J.F., 2012.Fundamentals of financial management. Cengage Learning. Retrieved on 14 January 2017. Frank, M.Z. and Goyal, V.K., 2009. Capital structure decisions: which factors are reliably important?Financial Management,38(1), pp.1-37. Retrieved on 14 January 2017. Froot, K.A., 2008. The intermediation of financial risks: Evolution in the catastrophe reinsurance market.Risk Management and Insurance Review, 11(2), pp.281-294. Retrieved on 14 January 2017. Grable, J.E. and Roszkowski, M.J., 2008. The influence of mood on the willingness to take financial risks.Journal of Risk Research,11(7), pp.905-923. 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