Derivatives — pros and cons

Blessing Nyatanga

Hull defined a derivative as a financial instrument with a value that is derived from the price of other basic underlying assets.

Derivatives markets help to improve the liquidity in the underlying asset markets by bringing hedgers and speculators together.

The ability to hedge encourages investors and traders to take bigger positions and the more active in the underlying markets, (Thorbeeke, 1995). A more active market environment with high liquidity in turn facilitates price discovery, which promotes economic efficiency.

It can be argued that derivatives are windows into market expectations and could be exploited for information about future price expectations for various types of financial assets and commodities.

The forward looking content is especially useful for regulators and policy makers when assessing the health of the financial system and the appropriateness of the monetary policy stance.

For instance, currency and interest rates swaps and futures contain valuable information about the outlook for the economy and the tightness of monetary conditions, which are very useful to central banks when making monetary policy decisions.

Derivatives have been very useful in mitigating risks faced by financial institutions. Many times, the trading of derivatives has been a success proving that derivatives, if traded well, may not be time bombs as Buffet Warren suggests.

The efficient operation of the financial system requires both the operation of hedgers and speculators. In order to protect the financial system from these dangers, in the post of Great Depression era, the US government created a strict financial regulatory system based on the studies of John Maynard Keynes (1930) and Hyman Minsky (1934) that worked effectively through the 1960s.

Derivatives bring about the ability to purchase large quantities of assets in two different markets simultaneously, exploiting price differences between SIMEX and the Osaka Stock Exchange.

The existence of parties that take advantage of such arbitrage opportunities provides market participants with a degree of certainty that they are not over paying for a product.

Derivatives allow risk transfer to risk averse investors that is bankers and others to off-set risk among themselves or transfer it to other players willing to accept the risk-return ratio.

By exchanging the right to buy and the right to sell, derivatives reduces the risk of price volatility to the other party if it happens to be a change in price in the market by comparing the price agreed at inception and the forward price.

Derivatives have gained notoriety as instruments of speculation in financial crisis, for example, in triggering the 1992 Exchange Rate Mechanism (ERM) crisis and the 1997 Asia financial crisis.

Speculative attacks were made on the Thai Baht through forward contracts and swaps which depleted the foreign reserves of the central bank and led to the collapse of the pegged exchange rate regime triggering the Asian financial crisis. In the 1994 Mexican peso crisis shows how derivatives can accelerate and deepen financial crisis.

Mexican banks were holding US$16 billion in tesobonos total return swaps at the time of the Mexican crisis. The initial peso devaluation at the onset of the crisis depressed the tesobonos price substantially and exposed the markets to a large next day collateral payments.

This could have accounted for a major part of the loss in foreign reserves by the Mexican Central Bank the day after devaluation (Sill, 1997).

This shows how margin calls on derivatives can accelerate the pace of a financial crisis. The greater the leverage that these instruments provide can also multiply the size of losses and thereby deepen a crisis.

The rapid increase of derivatives can create some major challenges to regulators and policy makers.

Derivatives lead to increase in moral hazard. This can be shown by using motor vehicle insurance product as an example. This is because these instruments can be regarded equivalent to an insurance product where a certain premium is paid for a certain amount of coverage in the event of an undesirable outcome.

By pooling the risk, insurance lowers the cost to individual motorists of owning and operating a car including the cost of being involved in an accident. However, the lower cost might induce some motorists to become more reckless in their driving and leads to more accidents.

Derivatives have the benefit of making underlying assets market more efficient. For example, derivatives markets produce information, that is, price discovery of underlying assets.

In a number of countries, the only reliable information about long term interest rates is obtained from swaps because swap market is more liquid and more attractive than the bond market.

However, the activity of trading derivatives among federally insured banks is thought to be an on going problem. The current crisis in Greece is partly due to trading of these financial securities. Warren Buffett refers to them as “time bombs” and “financial weapons of mass destruction,” but there is no doubt that even that he still uses them to hedge against risk.

The activities of trading derivatives provide irresistible financial gains and this have an effect of fuelling speculation which is harmful to the financial system. In his immortal words Buffet Warren said that derivatives lend themselves to huge amounts of speculation.

A well-known example of cases when derivatives have proved to be time bombs is in the US also known as the 2008 global financial crisis.

The episode of the Great Depression of 1929 gave governments a wakeup call and it was almost certain that all bubbles like all Ponzi schemes, inevitably collapse the only question being one of timing as explained by Emerson (1987) cited in Crotty (2002, p56).

Financial institutions and other companies should not be able to gamble at will. There is need to be transparency and agencies established to regulate the activities of companies that dabble in derivatives trading.

As has been explained earlier, activities of speculation may create bubbles riddled with perverse incentives. Crotty (2008, p2) explained that the incentives of the 2007 housing bubble enticed top executives in giant financial institutions, for example, at AIG where the company’s financial products unit gambled on credit default swaps.

This contributed substantially to AIG’s rising profits in the boom as the returns from these securities were robust according to Thomas et al (2010, p39).

In the aftermath of the financial collapse in the USA that began in1929, it was almost universally believed that lux regulation of financial markets makes the markets and institutions prone to fraud and manipulation by insiders, and there is a chance of these practices culminating into deep economic crises and political and social unrest.

Derivatives exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counter-parties.

Imagine then that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company.

The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades.

It all becomes a spiral that can lead to a corporate meltdown. Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counter-parties tend to build up over time.

A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. However under certain circumstances, an exogenous event that causes the receivable from Company A to go bad will also affect those from Companies B through Z.

It is argued that it was the over the counter derivatives that caused problems and systemic risk not exchange traded.

It is plain to reader of Warren Buffett’s letter that it is the over the counter derivatives that are being referred to as mass destruction and not the exchange traded derivatives where the counterparty risk is almost eliminated through the presence of the clearing house as all gains and losses are computed daily.

There is no default risk because the exchange traded are regulated and have standardised terms and contracts which are fixed.

The over the counter derivatives market is very much greater in size, thus it contains huge amounts of transactions when compared to the exchange traded derivatives market. The flexibility of over the counter derivatives makes them more suited to meet special requirements and lack a high order flow.

From the past painful experiences there is agreement on the dangers of derivatives. Derivatives can be dangerous if used incorrectly as several large companies were found in recent history.

However, there must be no confusion on the instruments of speculation with the underlying causes of the financial crises. Derivatives themselves can not cause currencies to depreciate or firms to go bankrupt. Financial crises occur because of fundamental imbalances in the economy.

Financial disasters related to the use of derivatives as a tool has led to the downfall of companies, it is rather the misuse and compromise which is a problem.

In a nutshell, it is vital to view a derivative market as a supplementary market, existing side by side with the underlying market to which they relate and from which they derive a significant portion of their value.

To these markets in turn, derivatives bring significantly greater dimension and flexibility, which currently is absent in the Zimbabwean financial markets.

Thus derivatives contribute to the completeness of the global market. However, derivatives can be said to bring failure of banks and other financial institutions.

Blessing Nyatanga holds a Bachelor’s Degree in Banking and Investment Management from NUST.0784909184/[email protected]