Impact of the Financial Crisis on Derivative Valuation

The financial crisis of 2007 highlighted some tremendous flaws within the financial industry. In a little over a year, close to $8 trillion was wiped out from the U.S. economy with significant ripples sent through out the global economy. The world’s largest economy had fallen victim to one of the most exotic and complex of financial instruments in the global economy: derivatives. With a present day market valued over 5x the domestic GDP, financial derivatives still play a major role within the industry. Furthermore, a very significant portion of the derivatives market is traded “over-the-counter ” with much less regulation. The derivatives market is still a significant player on the balance sheets of large financial institutions. As evident from the crisis, these institutions are pivotal factors to the health and vitality of our economy. Therefore, due to the immense size of the derivatives market and the vast influence of such instruments on our economy, serious reform, regulation, and risk evaluation was required to reign in the rampant market. For this paper, I will be analyzing the impact of the liquidity/credit crisis on derivative valuation. At the beginning of the 21st century, derivatives were