Posted in Finance, Accounting and Economics Terms, Total Reads: 628
Definition: Derivatives Time Bomb
Traditionally investors have used derivatives as an instrument to hedge their position in the market or to speculate on a given market condition or commodity. Thus any possible situation wherein all these derivatives positions held by hedge funds and large banks move against these parties will lead to the whole financial market to dive into a massive chaos. Such a situation is called derivatives time bomb.
Derivatives, as an instrument to hedge risk, are gaining more popularity among the investors. However this growing interest is both good and bad as though this derivative helps to mitigate risk, a highly leveraged position for an institution may lead to huge losses if the market positions move against them.
Events in past few years also prove this fact as many hedge funds imploded due to dramatic decline in their value forcing the investors to sell their securities at extremely low margins. One of the recent examples of hedge fund collapse due to adverse derivative position movement is Long term Capital Management (LTCM).