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Custom Essays - Finance Essays

The impact of financial derivatives in international finance

The impact of derivatives on financial markets represents a perspective that has its positive as well as negative points. The question is, are they more good than bad, or more bad than good?

As financial instruments crafted to creatively solve problems, and or generate new streams of profits, derivatives occupy both sides of the fence. This examination shall thus seek to look into the positive as well as negative aspects of these financial instruments, derivatives, and weigh the overall effect of their benefits against their drawbacks.

Chapter 1 – Introduction

A derivative represents a financial instrument whereby its worth is derived from the underlying value of an asset (Solomon, 1999, p. 111). Participants in the market thus do not trade, and or exchange the asset, rather they enter into an agreement whereby they exchange money, or assets, or another form of value at a date in the future, based upon the underlying asset (Solomon, 1999, p. 111). It is a transaction that entails a “… swap, forward, future, option, or a combination of these contracts that is ‘derived’ from an underlying asset such as a security or commodity, or from a rate such as an interest rate or exchange rate, or from an index such as a stock exchange …” (Solomon, 1999, p. 111).

 “Derivatives permit the hedging of risk and the swapping of financial features, such as the exchange of an asset or liability denominated in one currency for one denominated in another currency, or the exchange of a variable interest asset or liability for one with a fixed interest rate” (Solomon, 1999, p. 111). An option gives an investor the right but not the obligation “…to buy or sell an asset at a given price, which is called the ‘strike’ price. Assets in this instance can represent anything of intrinsic value, such as precious metals, stock or sometimes be as variable as an interest rate. Cocheo (1993) explains derivatives as “…contracts obligating the parties to make payments to each other, or one to the other, under specified circumstances”. And that they “…can be more broadly defined to include such "derived" securities as collateralized mortgage obligations and other structured financings such as asset-backed securities” (Cocheo, 1993).

Derivatives have a long history, thus their origin is worth mentioning. Sometimes referred to as ‘front contracts’, or “… contracts for deferred delivery …” derivatives “…were used for transactions on organized markets at least as early as those of medieval and Renaissance Europe …” (Cornford, 1996, p. 1). During that time frame “Alongside of the use of such contracts in the trading of goods, even then there was also speculation on foreign exchange rates by methods resembling derivatives” (Cornford, 1996, p. 1) they played an important part in financing areas that had no other means of obtaining funding or backing. The preceding is illustrated in sixteenth century Antwerp where “…wagers were made on foreign exchange rates at Spanish fairs …” and “…settled in a manner similar to the use of offsetting positions on modern futures exchanges …” (Cornford, 1996, p. 1). Greater transferability, ease of settlement along with the standardization of contract terms helped these forward contracts evolve into futures, with “… rice trading in seventeenth-century Japan…” “… often cited as furnishing the first historical example of a futures market in something like the modern sense” (Alletzhauser, 1990, p.) 26-27. From the mid part of the 19th century through the late 1960’2 futures and option trading on exchanges entailed commodities, with financial derivatives, primarily in the form of forward exchange contracts as well as share options mostly being supplied OTC (Cornfield, 1996). The tremendous “…growth of financial derivatives since the late 1960s is linked to the introduction of the trading on exchanges in an expanding range of financial futures and options” as demands in the global market have called for more creative solutions to financial needs (Cornfield, 1996).

This examination shall look into the impact of financial derivatives in international finance, delving into the manner in which they have, and are making their impact, the forms being utilized, and present day influence as well as future prospects.

Chapter 2 – Derivatives

A derivative can be loosely compared to the idea of a premium, whereby in the same manner that one pays a premium to an insurance company to obtain a form of protection for a specific area, there are types of derivatives that whereby the payoff is contingent based upon the occurrence of some type of event via which the premium to participate must be paid for in advance (Cocheo, 1993). The phrase ‘notional’ refers to the size of a derivative contract, and represents the figure that is utilized to calculate the payoff (The Derivatives Page, 2006). An example of the preceding is illustrated by supposing you have purchased a cash instrument, such as 100 shares of a particular company whereby the payoff is represented by a linear methodology whereby dividend impacts are disregarded (The Derivatives Page, 2006). For example, if those shares were purchased at $50, and the shares go down to $25, then $2500 has been lost as a result of the investment (The Derivatives Page, 2006). Instead of buying the shares, one has the option of purchasing a one month call option represented by a strike price of $50 that provides the right, however not the obligation to proceed with the purchase of the stock at a price of $50 one month later (The Derivatives Page, 2006). And example of the financial side of this transaction is revealed in the fact that the sample cost for the option to buy might amount to $700, as opposed to $5000 now. If the stock indeed goes up during the one-month period, then the option could be exercised, with the next benefit being that the exposure was just $700. Cocheo (1993) advises that derivatives are also sometimes termed ‘notionals’, and that there is a concern that they “…hold the potential of being the next financial crisis” as a result of systematic risk.

That idea stems from the proposition of ‘systematic risk’ which the Bank for International Settlements in 1992 defined as “The risk that a disruption (at a firm, in a market segment, to a settlement system, etc.) causes widespread difficulties at other firms, in other market segments or in the financial system" (Cocheo, 1993). Systematic risk represents the potential likelihood regarding the collapse of a financial system as in a stock market crash or in a breakdown as represented in the banking system (Duan and Wei, 2005). A lot of the concerns regarding derivatives is a result of some of these instruments being derived from other transactions such as “…interestrate and currency forwards; options; swaps; caps, floors, and collars; and their combinations and variations as well as related instruments” (Cocheo, 1993).

And a lot of that concern has a basis in fact!

In the recent past, derivatives have provided spectacular headlines with respect to their failures. Situations as befell companies such as the “… Long Term Capital Management, Orange County and Baring Brothers bring to mind situations where derivatives failed - often miserably” (McCarthy, 2000). The following illustrates the preceding:

Chart 1 – Derivative Losses in the 1990s
(Kettel, 1999)

In light of the preceding, one would reasonably expect that companies might have cut down their use of derivatives, which has not been the case. The global derivatives market grew to $270 trillion at the end of 2005, up from $98 trillion recorded in 2000, with predictions indicating that the phenomenal growth will continue (Pizzani, 2006). Growth in the derivatives market is being underpinned by Wall Street’s largest brokerage companies along with commercial banks that have, and are seeing extremely significant revenues as a result of their market activities in this quarter (Pizzani, 2006). The estimates indicate that brokerage firms, and commercial banks in 2006 will have generated approximately $33.2 billion in profits as a result of their derivatives business, in some cases accounting for between 8 and 10 percent of their overall revenues (Pizzani, 2006).

And this rampant rush for profits is what has a number of quarters concerned! Tett (2006) reports in an article written for the Australian, that “three of the world's most powerful financial regulators” have issued a ”… joint warning that individual nations cannot contain some of the risks …” represented by the growth of derivatives. They point to the failure of hedge fund Amaranth that lost $6 billion in U.S. gas markets during 2006 (Tett, 2006). The preceding predictions have also been repeated with warnings of a derivatives bubble as a result of the unimpeded growth the market has been experiencing (Ruppert, 2001). However, that prediction was made in 2001, and the derivatives market has exploded since that time. Derivatives “…are traded on both organized exchanges, and over-the counter (OTC) markets … (with) … an example of an OTC transaction is a contract offered by a bank or a securities firm that can be tailored to the needs of the user” (Solomon, 1999, p. 111).

In a speech conducted at the New York University Stern School of Business on 16 May 2006 by Timothy F. Geithner, the president and chief executive officer of the Federal Reserve Bank of New York, he stated that “Credit derivatives have contributed to dramatic changes in the process of credit intermediation, and the benefits of these changes seem compelling” (Federal Reserve Bank of New York, 2006). Geithner advised that credit derivatives have made substantial improvements in the manner of how credit risk is managed, and has aided in facilitating a broad distribution of that risk outside of the banking system (Federal Reserve Bank of New York, 2006). The preceding has aided in a broader spreading of credit risk whereby shocks are diffused as a result of a broad spread, as opposed to concentration (Federal Reserve Bank of New York, 2006).
Credit derivatives represent a contract to take the risk in the total return on the potential a credit asset might fall lower than the agreed level, and transfer it, without transferring the asset (Vaillant, 2001). The aforementioned is accomplished by transference of the risk on what is termed a credit reference asset (Vaillant, 2001). Credit derivatives come in many forms, with the most common known as follows (Moneyscience, 2007):

1. Credit Default Swap

This represents a ‘swap’ that is designed to transfer the credit exposure related to fixed income products. A credit default swap represents the most broadly utilized type of credit derivative. Briefly, it consists of an agreement consisting of the protection buyer, and the protection seller, with the buyer paying a periodic fee for the consideration of a contingent payment on the part of the seller in the instance of a credit event as evidenced by an example of a default of some type. In general, the majority of credit default swaps are settled physically wherein when a credit event does occur the protection seller has to pay what is termed the par amount of the agreement contract against the obligation of the protection buyer to deliver a loan or bond in the name for which the protection is covering.

The preceding sounds, and acts pretty much in the same manner as the way in which insurance operates, and a credit default swap acts in many ways like an insurance policy, however, since there does not exist a requirement to hold an asset, or to suffer a loss, the credit default swap is not in reality insurance. Usually credit default swaps run for a term of five years, however, because it is an over the counter derivative it can have any type of maturity.

The problem with derivatives that are brought on a speculative asset is that they are not either collateralized, nor are they guaranteed, thus the ultimate value of these type of derivatives is dependent upon the credit strength of the parties to the agreement. The problem that has been, and is being voiced on these types of instruments is that before the contract is settled the parties record their profits as well as losses on their statements without any money having changed hands. The foregoing represents the weakness in this type of derivative whose market has grown to the point whereby the amount of credit derivatives that are outstanding is substantially greater than the bonds outstanding for the same individual name. An illustration of the foregoing is that a company might have $1 billion outstanding in debt, with $10 billion in credit default swap derivatives on the books. The magnitude of the preceding comes to light in the event of default, whereby, for example, the debt recovery amounts to just 40 cents for each dollar. Thus the loss to the investors whom are holding the bonds would amount to $600 million, whereby the loss to the holders of the credit default swap would just be $6 billion.

1. Total Return Swap

A total return swap, which is also known as a total rate of return swap, represents a contract whereby a party to the agreement receives interest payments concerning a specific asset, and whereby the other party to the agreement receives a fixed or floating cash flow that is specified whereby the foregoing is not related to the credit worthiness of the asset referenced. The preceding is especially true where the payments involved are based upon the same notional amount. The underlying asset can represent any type of asset, index or combination, basket, of assets. Total return swap derivatives are very popular on bank loans that do not have what is known as a liquid repossession market.

The substance of a total return asset is that it permits one party the ability to derive the benefit, economically, of owning a particular asset, however it does not have to put said asset on its balance sheet, thereby permitting the other party, who does not retain the asset, to place such on their balance sheet, and thus buy protection against the potential of loss in the value of said asset. It is the delicate nature of these types of derivative deals that has resulted in the warnings as issued by the three financial regulators “…that individual nations cannot contain some of the risks …” represented by the growth of derivatives (Tett, 2006).

The difference between a total return swap, and a credit default swap it that the CDS represents protection against specified credit events. In a certain sense a total return swap is not actually a credit derivative in the real sense that a credit default swap is, as a total return swap is basically a funding / cost arbitrage.

1. Credit Linked Note

Credit linked notes are a security that is issued by what is known as a special purpose company, and or trust that is thus designed to offer to investors ‘par value’ at its maturity unless there is a referenced credit default. Par value represents in accounting, and finance a stated or face value. In the event of a default, the investors in a credit-linked note receive the recovery rate. Additionally, the trust will have also entered into the default swap arrangement with the dealer, and in the event of default then the trust pays the dealer the par, minus the indicated recovery rate which is in exchange for the annual fee that is thus passed onto the entities that invested in the methodology representing a higher yield with reference to their note. The overall purpose of the credit linked note arrangement is to pass a specific default risk on to investors that are willing to take the risk for the higher yield that is made available as the credit linked note is typically backed via a highly rated collateral such as United States Treasury securities, thus making them very desirable. A credit linked note represents a security that has an credit default swap embedded, such thus allows the issuer the ability to transfer specific credit risks onto credit investors.

Special Purpose Companies, also known as SPC’s, or trusts, are the mechanism through which credit linked notes are created, with such collateralized via AAA rated securities. The securities are brought from the trust paying a fixed, and or floating coupon, and at its maturity the investors at provided with par, unless the credit in the note defaults, and or declares bankruptcy whereby they then receive a sum that is the same as the recovery rate.

In order to understand the impact of credit derivatives on international finance, the foregoing explanation of credit default swap, total return swap, and credit-linked note was necessary to equate the influence in this context. They are, credit derivatives, designed to permit the independent trading as well as hedging of credit risk(s) whereby it is possible to transform, and or transfer said risk by securitization. The term securitization represents a group of techniques that are utilized in the transformation of illiquid cash flow sources into securities that are tradable. The foregoing, illiquid cash flow sources can be commercial, and or home loans, credit card accounts, vehicular loans, consumer loans, illiquid bonds, aircraft leases, and corporate home loans.

Chapter 3 – Impact of Credit Derivatives and Other Derivatives

An while the spectacular losses that have occurred in the credit derivatives market have garnered headlines, what gets lost in the translation is that the market continues to grow at phenomenal rates! That seemingly signals other facets that are inherent within the credit derivatives market fueling the growth. Profits represent one aspect, however, without a sound business related underpinning firms could not really utilize the methodology without such seemingly looking like market gambling. The benefit of credit derivatives to corporations, investors, and the economy is that they provide investors with opportunities that otherwise might not be available in terms of derivative securities, credit, options, forwards, and futures Bank for International Settlements (2000).

The risks that are attributed to derivatives represent the manner in which they are utilized in the market. In equating the manner in which credit derivatives impact upon international finance, a survey conducted by the International Swaps and Derivatives Association (2004) among finance professors at the top fifty business schools in the United States resulted in a response from 84 professors at 42 institutions. The following are the responses to that questionnaire (International Swaps and Derivatives Association, 2004):

1. “Managing financial risk more effectively is a way for companies to build shareholder value”

1. 98% of the respondents to the survey agreed with this statement
2. 44% strongly agreed,
3. 47% indicating that they agreed,
4. 7% stating that they somewhat agreed,
5. 2% of the respondents somewhat disagreed

2. “Derivatives help companies manage financial risk more effectively”
1. 100% of the respondents agreed with the preceding statement as represented in the following manner:

1). 49% strongly agreed,
2). 43% agreed
3). 8% somewhat agreed

2. Respondents commonly cited the benefit provided represented the ability of companies to utilize derivatives to enable them to customize the risk profile of companies and assume those risks which added value.

3.  “Derivatives will continue to grow in use and application”
1. 54% strongly agreed,
2. 38% agreed,
3. 8% somewhat agreed
4. In their responses, a majority of the respondents stated that credit risk represented the area that in the future would most likely benefit from innovations.

4. “Derivatives have not created new types of risk, they simply allow existing risks to be managed better”
1. 55% agreed overall with the preceding statement, in the following manner:

1). 15% strongly agreed
2). 23% agreed
3). 17% somewhat agreed
4). 18% somewhat disagreed
5). 27% disagreed

5. “The impact of derivatives on the global financial system is beneficial.”
1. 99% of the respondents to the survey agreed with this statement

1). 28% strongly agreed
2). 53% agreed
3). 18% somewhat agreed
4). 1% somewhat agreed

2. The respondents indicated the derivative use by companies represented a cost effective means via which the transfer of risk is accomplished and that the contribution of derivatives aid in the stability of the global financial system.

6. “The risks of derivatives have been overstated”.
1. 81% agreed with this statement

1). 9% strongly agreed
2). 37% agreed
3). 35% somewhat agreed
4). 10% somewhat disagreed
5). 9% disagreed

The results of the preceding survey aid in putting the worth, and impact of derivatives into overall perspective. Given that 99% of college professors see derivatives as beneficial to the global financial system, and that 81% think the risks of derivatives has been overstated, the beneficial effect seemingly is positive.

The global financial system since the mid 1990s has experienced periods of high asset price volatility, which derivatives have helped to stabilize as a result of the unique approaches to writing debt, which in many cases is just forestalling a deeper problem still seeking a solution (Barham, 2001, pp. 40-43). During the period since the mid 1990s, the global financial markets have been characterized by asset pricing, and capital flows volatility, which has raised the issue of how emerging market financial, and economic systems, a major contributor to the growth in derivative use, can be made to be more resilient with respect to such volatility (Calvo, 1998, pp. 35-54). The case for the beneficial effects of financial derivatives in emerging market volatility represents one of the positive impacts that these types of instruments have, and are having in their contribution to international finance.

The mid and late 1990s, as well as into 2000, and beyond has seen this volatility grow during this period along with the inclusion of what are termed ‘sudden stops’ or in some cases reversals of capital flows that represented key features of the most severe banking, and balance of payments crisis (Calvo, 1998, pp. 35-54). Examples of the preceding can be found in the crisis in Mexico in 1995 as well as the Asian crisis that occurred in 1997 (Calvo, 1998, pp. 35-54). Important elements within the preceding were represented by the problems in the banking system’s debt servicing difficulties as represented by large domestic corporations with huge debts in foreign currency (Calvo, 1998, pp. 35-54). The aforementioned ‘sudden stops’ reflected concerns on the part of investors regarding the weaknesses in political as well as economic financial systems of emerging markets that impacted upon investor appetites’ for risky assets (Calvo, 1998, pp. 35-54). The foregoing, when lumped together, all contributed to a reduction in the ability of emerging markets to access international financial markets (Calvo, 1998, pp. 35-54).

The foregoing gives rise to the question as to how emerging markets will be, or would be able to attain an increased level of stable access to international financial markets as well as how their economies would be able to cope with volatility whenever it occurred (Calvo, 1998, pp. 35-54). Scheerer (2001) advises that the “… real test for credit derivatives …” occurred during the Asian financial crisis in 1997. He states that “… credit derivatives performed more efficiently …” in that crisis than did the bond market. Scheerer (2001) points out that credit derivatives permitted investors the recovery of around “… $800 million from the Korean Development Bank…” along with “… the Industrial Finance Corporation of Thailand...” he also points to the”… turmoil in the Russian financial markets …” as another example whereby “… credit derivatives had to face another even more intense stress test” (Scheerer, 2001). In that instance credit derivatives were “… brought as insurance against devaluation of the Ruble and Russian government default”.

The foregoing represents some examples of the problems encountered in emerging markets that derivatives aided in either solving problems, or forestalling an economic, and financial meltdown. Derivatives in the emerging markets financial crisis have allowed these markets time to shore up various policies as well as avoid a complete stoppages of investor confidence, even though they were subject to ‘sudden stops’ as indicated by Calvo (1998, pp. 35-54). During, and since that time most of the emerging markets have taken as well as implemented added measures that have been, and are designed to ‘self insure’ against the potential of volatile asset prices, and capital flows (Feldstein, 1999). The foregoing ‘self insure’ measures consist of the following broad categories (Feldstein, 1999) and (Hyeon-Jin, 2002):

1. changes in the liability as well as external asset management practices,
2. the adoption of arrangements for exchange rates to match the degree of openness in capital account transactions,
3. a strengthening of financial institutions on a domestic level, along with the enhancement of regulation, and supervision to increase the resistance to volatility, and,
4. the development of local derivative, and securities markets as a measure to provide for alternative sources of funding in the corporate and public sectors as well as  the facilitation in the management of financial risks that are associated with high asset price volatility periods

After the Asian crisis in 1997, it was suggested emerging markets should increase international reserve holdings as a provision representing ‘self insurance’ against capital flow reversals (Feldstein, 1999).  The development of local derivatives markets has been a large part of the foregoing as a result of it being a vehicle for the management of financial risks, particularly related to exchange and interest rates (Fischer, 2001, pp. 3.24). In terms of the risks faced by banks with respect to interest rate risk as financial intermediaries, derivatives have and are playing an important role on the international stage (Hirtle, 1998). It, interest rate risk, represents the risk a bank’s income might be adversely impacted as a result of changes that are unanticipated in interest rates (Hirtle, 1998). The foregoing is a result of bank’s roles as financial intermediaries, whereby they accept liabilities that are interest sensitive as well as invest in assets having the same interest sensitive properties (Hirtle, 1998). Basically, the problem stems from mismatches as represented by the maturity of assets, off balance sheet positions, and liabilities which all can help lead to volatility in both net worth, and income resulting from the rising and or falling of interest rates (Hirtle, 1998).

Derivatives have played an important role in the preceding, which has impacted global financial markets as well as a result of limiting bank exposure to the concern’s of interest rate fluctuations (Hirtle, 1998). Banks have come to increasingly use derivatives as a solution to the preceding, however, such has given rise to concerns that banks are, and have been facing another form of risk as a result of the use of derivatives to solve the preceding problem. Derivatives represent a relatively cost effective means whereby banks can alter their exposure to interest rates, as opposed to the methodology employed without such instruments (Hirtle, 1998). Under the secondary method, banks could adjust their risk exposures to interest rates primarily by alteration of their asset, and liabilities composition (Hirtle, 1998). However the drawback is that such adjustments in the portfolio of banks might also result of a disruption of the overall business strategy, which could include provisions for emerging markets that would have to be either cut back, and or eliminated (Hirtle, 1998). The preceding provides an illustration how derivatives in various sectors as well as forms contributed to the stability in financial markets, even though these instruments carry, and have their own inherent risks.

Chapter 4 – Conclusion

The question as to whether derivatives have an impact on global financial markets can be answered as a resounding yes. If one opts to look at derivative from the position of the meltdowns of such companies as Long Term Capital Management, loss of $4,000,000,000, Baring Brothers, loss of $1,240,500,000, and other failures of derivatives on a mass scale, one is concentrating primarily upon the failure in decision making by a few individuals and or set of circumstances that resulted in tremendous implications and impacts, as opposed to the failure of derivatives as instruments. Evidence as to the beneficial contribution of derivatives to global financial markets has been proven time and time again, as shown by the examples of the Asian financial crisis, as well as the contribution of derivatives to banking, credit rate enhancement measures, interest rate stability options, and emerging market options to limit volatility, and sudden stops.

The preceding does not eliminate the fact that derivatives themselves present as well as pose risks in their methods of solving problems, much as in the case of an operation to remove a cancer, or fix a broken bone have their own inherent risks as well. It simply is a question of the risks that existed before the installation of derivative solutions were causing and creating directions, and congestion that would not clear itself. Derivatives are at times sort of a band aid as well as diagnosis, operation, and health plan, depending upon the situation, and or application they are being put to. In many instances, using the emerging markets as an example, they aided in clearing congestion as caused by risk being unacceptable, and brought time for national economies, and banks to set into place measures and solutions that would provide long term corrections. Thus, in many cases derivatives are a stopgap measure, whereas in others they are the long-term solution.

Thus derivatives represent an instrument whereby financial creativity can be employed to either correct, forestall, and or band aid a problem, thus permitting markets to continue as opposed to halt for corrections or fixes, which they eventually do on the fly with derivatives getting them to the next gas station. The problem in financial markets is that one cannot stop the vehicle to fix tires, engines, transmissions or brakes; everything is done while markets are in motion. The Mexican, and Asian crisis’ showed the massive negative effects when the vehicle stops, as everything behind it also must brake, thus resulting in a multiplier effect that fuels bailouts. Derivatives may not represent the perfect solution in all cases, or even the best solution overall, however time and time again these creative instruments have proved their worth in maintaining, fixing, permitting, and allowing business as usual to continue, and in many cases to be enhanced.

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