Risk management Essay Example | Topics and Well Written Essays - 3000 words

Risk management - Essay Example This created a bubble in the housing finance sector and mortgage properties. Investment banks and other financial institutions started to lend money to the mass of people as well as corporate houses for purchase of land or other business purposes. The land and housing properties were kept as mortgage serving as underlying securities for those loans. These loans were granted to the borrowers without looking at repayment feasibility of the loans or without carrying out adequate evaluation of the credit parameters. The credit parameters like income of the borrower, assets available to service the loan, existing liabilities, etc. were ignored by the financial institutions in the mortgage loans. This led to the inflation of the bubble in the housing sector which developed earlier. The bubble finally burst as the borrowers were unable to repay the loans and the defaulters in the mortgage loan market started to become heavy. This led to the devaluation of the mortgages which served as under lying securities. ... w of information to the market led to the erosion of investors’ confidence that reflected in the plunge of share prices of the company (Allen, 1999, p.24). Huge wealth of the investors was eroded in short time thereby causing a situation of liquidity crisis. Several companies like Lehmann Brothers, Bear Stearns, Meryl Lynch, etc. were affected due to fall in the valuation of the companies and inability to return the investment of the shareholders. The liquidity crisis created shortage of monetary supply in the economy which tightened the credit conditions in the economy. This created a global credit crisis which was fuelled by the implementation of revised regulatory standards, enforcement of strict credit parameters and revised policies of the companies to counter the global financial crisis. Role of financial engineering: derivative products were a risk management device Derivatives products are financial instruments that derive its value from the underlying assets such as s tock, interest rates, currencies, commodities, etc. Derivative products involve two parties entering into a contract for payment of a certain amount on a certain date under the agreed terms and conditions. The derivative products may be of two types, namely â€Å"lock† and â€Å"option† derivatives. The lock derivatives enforce the parties entering into the contract to fulfil the payment obligations of the derivative product as per terms and conditions. The â€Å"option’ derivative provides the right to the buyer to enter into the contract but the buyer is not obligated to enter into the contract in â€Å"option† derivatives. The derivative products are used to hedge financial risks and also to speculate financial gains in the time of adverse financial situations. The derivative products were used a