Banking Industry Meltdown Essay

1. What are the ethical risks associated with derivatives?

One of the ethical risks associated with derivatives is that they expose investors to counter-party risk. If a business wants a fixed-rate loan, but the bank only has variable rate loans, the business swaps payments with another business that wants a variable rate, creating a fixed rate for the first business. The catch is, if the first business goes bankrupt, the first business loses the fixed rate and has to pay the variable rate. When interest rates increase substantially businesses can’t pay back the loan, which in turn causes a chain reaction of failures. Derivatives also pose high risks for small inexperienced investors.   I liked the statement by Warren Buffett about derivatives; he said they are “financial weapons of mass destruction”. (Ferrell, 8th Edition, p. 403)This statement seems to ring true about derivate; they can definitely make or break a company.

Derivatives are used in sales transactions where there is opportunity for financial rewards. However, managers and traders often do not take into account the level of risk for investors or other stakeholders. If the risk is not communicated to the investor it can result in deception or even fraud. Some traders and managers have lost sight of everything but their incentives for selling them and making profit.

In conclusion, Derivatives are financial instruments with values that change relative to underlying variables. The ethical risk that derivatives pose is that they can be very risky for inexperienced investors. Derivatives offer a large reward but can be a major risk if they are not aware of the investment that they are making at the time. Another ethical risk is that the mangers and traders are not taking into consideration the risk of their stakeholders and investors who have entrusted their investments. The last ethical risk is that they are being deceptive and not letting the investors know by not communicating with them the risk;...