1. Introduction
As an important tool in modern financial markets, financial derivatives have been widely used in risk management, especially in avoiding market fluctuations, interest rate risks, exchange rate risks, and other uncertinties. In recent years, scholars and financial institutions have increasingly focused on exploring the applications of derivatives in risk management, as well as understanding their potential risks While derivatives offer significant benefits to financial markets, their excessive use or improper application can lead to systemic risks. For example, when the global financial crisis broke out in 2008, the huge scale and complexity of the derivatives market exposed the fragility of the financial system. During the subprime mortgage crisis, the risk hedging and speculation of financial institutions through derivatives profoundly affected the stability of the global economy [1].
This research focuses on the practical application of financial derivatives in risk avoidance, and selects JPMorgan Chase's operations during the 2008 financial crisis as a case study. This study explores the application of financial derivatives in risk avoidance, focusing on analysing its use in actual financial crises, especially JPMorgan Chase's derivatives strategy in the 2008 crisis. The significance of the research lies in its potential to provide valuable insights and practical guidance for financial institutions in their use of derivatives. It also offers recommendations on how future institutions can reasonably manage and mitigate the risks associated with derivative use.
2. Basic Concepts and Classification of Financial Derivatives
Financial derivatives are financial instruments whose value is derived from other underlying assets (such as stocks, commodities, currencies, interest rates, etc.) [2]. The formation of the derivatives market has provided market participants with the ablity to hedge potential risks through derivative instruments in an environment of price fluctuations. Financial derivatives can be roughly divided into many categories [2]. These derivative instruments not only provide market participants with flexible risk management tools but also provide investors with abundant speculative opportunities. According to their main uses, financial derivatives can be divided into three main types: hedging, speculation, and arbitrage [2]. This research will focus on the application of financial derivatives in risk hedging, particularly how they can help companies avoid potential financial risks when market uncertainty is high.
3. Application of Financial Derivatives in Risk Avoidance
The primary role of financial derivatives in risk avoidance is hedging. Hedging is to offset potential risk exposure by taking opposite market actions [3]. Different types of financial derivatives can address to different needs in the hedging process.
3.1. Risk Avoidance in Commodity Markets
For companies that produce and consume commodities, fluctuations in commodity prices may bring huge operating risks. Many companies use futures contracts to lock in future purchase or sales prices to avoid the risks brought by price fluctuations [4]. For example, airlines may hedge the risk of future oil price increases by purchasing fuel futures. Similarly, shipping companies and agricultural enterprisesoften use futures contracts to hedge the risk of commodity price fluctuations.
3.2. Risk Avoidance in Foreign Exchange Markets
Multinational companies often face the risk of exchange rate fluctuations, especially in the case of frequent cross-border transactions, where exchange rate fluctuations can cause fluctuations in their revenue and costs. To mitigate the risk,, multinational companies usually use derivative tools such as foreign exchange futures and foreign exchange options for hedging [5]. For example, Apple Inc., a large American technology company, employs foreign exchange options and forward contracts to lock in future foreign exchange income, thereby avoiding the impact of exchange rate fluctuations on its global business [6].
3.3. Risk Avoidance in the Interest Rate Market
Interest rate fluctuations can significantly impact companies that rely on borrowing for financing, especially when borrowing costs rise, which may increase the financial pressure on companies. Interest rate swaps are a commonly used hedging tool[5]. By using interest rate swaps, companes can convert floating rate loans into fixed rate loans, thereby avoiding the cost risks brought about by future interest rate increases. For example, a company may change the interest payment of a floating rate loan to a fixed rate, thereby locking in the future repayment amount.
4. JPMorgan Chase's Use of Derivatives in the 2008 Financial Crisis
The 2008 global financial crisis, largely triggered by the US subprime mortgage crisis, led to significant turmoil in the global financial system. During this backdrop, JPMorgan Chase, one of the world's largest investment banks, utilized derivatives such as credit default swaps (CDS) and interest rate swaps to manage risk[7]. While the collapse of the real estate market and the spread of the credit crisis caused significant losses for many financial institutions holding subprime-related assets, JPMorgan Chase effectively hedged some of its exposure through these financial instruments, mitigating potential losses.
4.1. JPMorgan Chase's Derivatives Operations
A credit default swap (CDS) is a derivative contract that allows investors to receive compensation in the event of a debt default by paying a periodic fee. JPMorgan Chase had began to use CDS extensively before the 2008 financial crisis, particularly to hedge its risk exposure in the subprime mortgage market. According to JPMorgan Chase's financial report, the total amount of CDS contracts held by JPMorgan Chase reached approximately US$1.6 trillion at the end of 2007, most of which were linked to assets related to US subprime mortgages [8].
In 2008, as the US real estate market collapsed and subprime mortgage-related debts began to default, the value of CDS contracts surged. JPMorgan Chase used these derivatives to transfer some of its subprime risk exposure to other market participants, reducing its potential losses. For example, the bank protected over US$5 billion worth of subprime mortgage assets by signing CDS contracts with other financial institutions [9].
4.2. JPMorgan Chase's CDS Trading Results
JPMorgan Chase avoided a large number of potential losses during the 2008 financial crisis by using the protection obtained in the CDS market. According to JPMorgan Chase's public data, iCDS contracts helped the company reduce its risk exposure by about 20%. In particular, in 2008, JPMorgan Chase's losses in the subprime mortgage market were partially protected by CDS, limiting the scale of financial losses [10].
JPMorgan Chase assumed a large amount of the company's risk in the subprime mortgage crisis in an important transaction with Bear Stearns on March 30, 2008. JPMorgan Chase helped Bear Stearns avoid subsequent debt default exposure by purchasing credit default swap protection. Although this transaction carried certain risks, it prevented JPMorgan Chase from suffering greater losses to a certain extent. According to JPMorgan Chase's public financial reports, the company ultimately avoided more than $5 billion in potential losses through a series of CDS contracts and other derivative transactions. However, the company also acknowledged that, despite these hedges, it could not completely avoid the broader market turmoil caused by the crisis.
4.3. JPMorgan Chase's Risk Management and Crisis Response
While JPMorgan Chase effectively hedged certain risks with derivatives, it faced significant challenges in managing risks during the extreme volatility of the 2008 financial crisis. The extreme volatility of global stock markets, commodity markets, and foreign exchange markets made it difficult for some financial institutions to adjust their derivatives positions in a timely manner, including JPMorgan Chase.
The JPMorgan Chase case demonstrates that derivatives, while useful, have limitations, particularly during a crisis. [11]. The extreme market instability exacerbated liquidity risk and counterparty risk, which can lead to concentrated risk exposure in the derivatives market. In addition, some of JPMorgan Chase's derivatives transactions also reveal the shortcomings of its internal risk management mechanism. For example, when the financial crisis broke out in 2008, JPMorgan Chase once faced relatively low liquidity and had difficulty in quickly closing some derivatives positions, resulting in financial losses in the short term.
4.4. Case Summary
JPMorgan Chase's experience during the 2008 financial crisis highlights both the potential and challenges of using derivatives in financial risk management. The company leveraged instruments such as credit default swaps (CDS) and interest rate swaps to hedge credit and interest rate risks, successfully avoiding approximately $5 billion in losses. However, this approach did not fully shield it from systemic risks brought by the crisis[12]. The heavy reliance on derivatives and high-leverage strategies exposed the company to additional financial vulnerabilities, underscoring the risks inherent in these instruments. The challenges faced by JPMorgan Chase in using derivatives were multifaceted. During the crisis, the liquidity of the derivatives market declined sharply, making it difficult for the bank to adjust its positions effectively. Additionally, issues such as valuation inaccuracies and gaps in risk management further complicated the use of derivatives.
These limitations reveal that while financial derivatives can serve as powerful tools for mitigating risk, they must be used cautiously. Financial institutions should strengthen the transparency and adaptability of their risk management frameworks to navigate volatile market conditions and mitigate the broader risks associated with derivatives.
5. Risks and Regulatory Challenges in the Use of Financial Derivatives
While financial derivatives are valuable tools for mitigating market risks, their use is aligned with hidden dangers. Particularly during periods of extreme market volatility, issues such as liquidity constraints and a lack of transparency in the derivatives market can lead to increased risk exposure and potential financial losses.
5.1. Liquidity Risk
In an environment of extreme market volatility such as a financial crisis, the liquidity of derivatives may drop significantly, resulting in the inability to quickly close or adjust derivatives positions, thereby increasing risk exposure [13]. JPMorgan Chase, for example encountered this problem during the 2008 financial crisis when the liquidity in the CDS market sharply declined. This liquidity squeeze prevented the bank from performing timely hedging operations, exacerbating its risk exposure [13].
5.2. Counterparty Risk
Derivative transactions usually involve multiple market participants, meaning that if one party defaults, the other party may also face losses. During the 2008 financial crisis, some financial institutions failed to perform their obligations due to debt defaults, resulting in huge credit risks on the counterparties [14]. While JPMorgan Chase mitigated counterparty risk through multi-party hedging strategies, other financial institutions failed to effectively manage this risk.
5.3. Regulatory Risks
The complexity and opacity of the financial derivatives market pose significant regulatory challenges. The 2008 financial crisis exposed the regulatory deficiencies in the global derivatives market, especially the lack of regulation of shadow banking and over-the-counter derivatives trading, which led to financial institutions engaging in high-leverage, over-speculative trading in an environment without adequate regulation. Although global financial regulators have strengthened their supervision of the derivatives market after the crisis, the complexity of the derivatives market continues to challenge the effectiveness of regulation.
6. Future Development Trends of Financial Derivatives in Risk Management
With the continuous development of the financial market, the types and usage scenarios of financial derivatives will continue to expand. In the future, the risk management function of financial derivatives will remain crucial in various fields, especially in the process of dealing with market uncertainties and price fluctuations [15]. However, balancing the risks and benefits of derivatives, ensuring that they do not cause new systemic risks, and promoting their responsible use will be key to the future development of financial derivatives.
6.1. The Combination of Financial Technology and Derivatives
With the rapid development of financial technology, technologies such as artificial intelligence, big data analysis, and blockchain have been gradually applied to derivatives trading and risk management. Through more accurate data analysis and intelligent risk assessment, financial institutions can better understand market risks and optimize the use of derivatives [16]. In the future, innovations in financial technology are expected provide stronger support for the transparency and liquidity of the derivatives market and further reduce systemic risks.
6.2. Strengthening Supervision and Transparency
After the 2008 financial crisis, financial regulators in various countries have strengthened supervision of the derivatives market, especially for over-the-counter derivatives (OTC) transactions [17]. With the continuous improvement of the global financial regulatory system, the regulatory transparency of the derivatives market will be further improved, reducing counterparty risk and information asymmetry in derivatives transactions.
6.3. Popularization of Derivatives Risk Education
Although financial derivatives are essential in risk management, their complexity and leverage characteristics can lead to serious financial losses if misused. In the future, financial market participants, especially enterprises and investors, need to strengthen education and training on derivatives, improve their risk identification and management capabilities, ensuring that derivatives are used appropriately and effectively.
7. Conclusion
The application of financial in risk management demonstrates their crucial role in the financial market. Derivatives offer powerful tools for mitigatng risks such as commodity price fluctuations, exchange rate changes, and interest rate fluctuations, derivatives provide companies and financial institutions with powerful hedging tools. The use of derivatives by JPMorgan Chase during the 2008 financial crisis illustrates that while derivatives can effectively reduce certain risks, excessive reliance on, and misuse of, these instruments can lead to substantial financial risks.
The use of financial derivatives requires careful consideration. Market participants should reasonably configure derivative tools based on their own risk tolerance and strengthen their ability to predict market fluctuations. In addition, the advancement of financial technology and the continuous strengthening of supervision provide guarantees for the healthy development of the derivatives market. As the derivatives market and associated technologies evolve, the role of derivatives in risk management will become increasingly important. However, market participants must fully recognize their potential risks and take effective risk prevention measures. d prospects and development space in risk hedging.
While this study demonstrates the benefits of financial derivatives, some limitations remain. The reliance on a single case study, such as JPMorgan Chase, highlights the need for further research involving a wider range of financial institutions to better understand the broader implications of derivatives use. Additionally, as financial technology continues to advance, tools like blockchain and artificial intelligence offer significant potential to enhance transparency and reduce risks in derivatives markets, warranting further exploration. Lastly, strengthening regulatory frameworks and improving education on derivatives can ensure their effective and responsible use while minimizing potential risks.
Acknowledgements
During the process of writing the thesis, the selfless help and patient guidance of the tutor provided great help!
References
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[4]. Williamson O. E. Transaction-Cost Economics: The Governance of Contractual Relations [J]. The Journal of Law and Economics, vol. 22, no. 2, 2020, pp. 233-261.
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[7]. Mizen P. The Credit Crunch of 2007-2008: A Discussion of the Background, Market Reactions, and Policy Responses [J]. Review, vol. 90, no. 5, 2008, pp. 531-568.
[8]. Duffie D, Zhu H. Does a Central Clearing Counterparty Reduce Counterparty Risk? [J]. Review of Asset Pricing Studies, vol. 1, no. 1, 2011, pp. 74-95.
[9]. Graafland J. J., van de Ven B. W. The Credit Crisis and the Moral Responsibility of Professionals in Finance [J]. Journal of Business Ethics, vol. 103, no. 4, 2011, pp. 605-619.
[10]. Acharya V. V., Brownlees C. T., Engle R. F., Farhang Farazmand, Richardson M. Measuring Systemic Risk [M]. Regulating Wall Street, 2011, pp. 85-119.
[11]. Cont R, Minca A. Credit Default Swaps and Systemic Risk [J]. Annals of Operations Research, vol. 247, no. 2, 2015, pp. 523-547.
[12]. Teece D. J. Dynamic Capabilities: Routines versus Entrepreneurial Action [J]. Journal of Management Studies, vol. 49, no. 8, 2022, pp. 1395-1401.
[13]. Fleming M. J., Jackson J. P., Li A., Sarkar A., Zobel P. An Analysis of OTC Interest Rate Derivatives Transactions: Implications for Public Reporting [J]. SSRN Electronic Journal, vol. 7, no. 3, 2012, pp. 1-20.
[14]. Langley P. In the Eye of the “Perfect Storm”: The Final Salary Pensions Crisis and Financialisation of Anglo‐American Capitalism [J]. New Political Economy, vol. 9, no. 4, 2004, pp. 539-558.
[15]. Avgouleas E, Kiayias A. The Promise of Blockchain Technology for Global Securities and Derivatives Markets: The New Financial Ecosystem and the “Holy Grail” of Systemic Risk Containment [J]. European Business Organization Law Review, vol. 20, no. 1, 2019, pp. 81-110.
[16]. Cont R, Kokholm T. Central Clearing of OTC Derivatives: Bilateral vs Multilateral Netting [J]. Statistics & Risk Modeling, vol. 31, no. 1, 2014, pp. 1-22.
[17]. Graafland J. J., van de Ven B. W. The Credit Crisis and the Moral Responsibility of Professionals in Finance [J]. Journal of Business Ethics, vol. 103, no. 4, 2011, pp. 605–619.
Cite this article
Chien,W. (2025). Research and Examples on the Application of Financial Derivatives in Risk Avoidance. Advances in Economics, Management and Political Sciences,164,56-61.
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References
[1]. Hellgren Z, Serrano I. Transnationalism and Financial Crisis: The Hampered Migration Projects of Female Domestic Workers in Spain [J]. Social Sciences, vol. 26, no. 1, 2017, pp. 8.
[2]. MacCarthy J. The Effect of Financial Derivatives on the Financial Performance of Firms in the Financial Sector in Ghana [J]. SSRN Electronic Journal, vol. 12, no. 4, 2016, pp. 1-15.
[3]. Bouchaud J. P, Potters M. Theory of Financial Risk and Derivative Pricing: From Statistical Physics to Risk Management [M]. Cambridge University Press, 2011, pp. 85-120.
[4]. Williamson O. E. Transaction-Cost Economics: The Governance of Contractual Relations [J]. The Journal of Law and Economics, vol. 22, no. 2, 2020, pp. 233-261.
[5]. Ding Q, Dong L, Kouvelis P. On the Integration of Production and Financial Hedging Decisions in Global Markets [J]. Operations Research, vol. 55, no. 3, 2007, pp. 470-489.
[6]. Carter C. A. Futures and Options Markets: An Introduction [M]. Rebeltext/Createspace, 2018, pp. 10-50.
[7]. Mizen P. The Credit Crunch of 2007-2008: A Discussion of the Background, Market Reactions, and Policy Responses [J]. Review, vol. 90, no. 5, 2008, pp. 531-568.
[8]. Duffie D, Zhu H. Does a Central Clearing Counterparty Reduce Counterparty Risk? [J]. Review of Asset Pricing Studies, vol. 1, no. 1, 2011, pp. 74-95.
[9]. Graafland J. J., van de Ven B. W. The Credit Crisis and the Moral Responsibility of Professionals in Finance [J]. Journal of Business Ethics, vol. 103, no. 4, 2011, pp. 605-619.
[10]. Acharya V. V., Brownlees C. T., Engle R. F., Farhang Farazmand, Richardson M. Measuring Systemic Risk [M]. Regulating Wall Street, 2011, pp. 85-119.
[11]. Cont R, Minca A. Credit Default Swaps and Systemic Risk [J]. Annals of Operations Research, vol. 247, no. 2, 2015, pp. 523-547.
[12]. Teece D. J. Dynamic Capabilities: Routines versus Entrepreneurial Action [J]. Journal of Management Studies, vol. 49, no. 8, 2022, pp. 1395-1401.
[13]. Fleming M. J., Jackson J. P., Li A., Sarkar A., Zobel P. An Analysis of OTC Interest Rate Derivatives Transactions: Implications for Public Reporting [J]. SSRN Electronic Journal, vol. 7, no. 3, 2012, pp. 1-20.
[14]. Langley P. In the Eye of the “Perfect Storm”: The Final Salary Pensions Crisis and Financialisation of Anglo‐American Capitalism [J]. New Political Economy, vol. 9, no. 4, 2004, pp. 539-558.
[15]. Avgouleas E, Kiayias A. The Promise of Blockchain Technology for Global Securities and Derivatives Markets: The New Financial Ecosystem and the “Holy Grail” of Systemic Risk Containment [J]. European Business Organization Law Review, vol. 20, no. 1, 2019, pp. 81-110.
[16]. Cont R, Kokholm T. Central Clearing of OTC Derivatives: Bilateral vs Multilateral Netting [J]. Statistics & Risk Modeling, vol. 31, no. 1, 2014, pp. 1-22.
[17]. Graafland J. J., van de Ven B. W. The Credit Crisis and the Moral Responsibility of Professionals in Finance [J]. Journal of Business Ethics, vol. 103, no. 4, 2011, pp. 605–619.