The Power of Derivatives in the Global Financial System

Contents

I. Introduction

II. Discussion
1. Defining derivatives
2. General purpose of derivatives
3. Addressing the main risks
4. Derivatives: leading to complex banking & immediate effects for investors
5. Systemic predicaments arising from derivatives
6. Extensive popularity of complex derivative products
7. The Power of Derivatives-derived from extensive market share and entanglement

III. Conclusion

IV. Tables

V. References

This work is to discuss the role and power of derivatives in the global financial markets and its ability to reduce, diversify and enhance risks associated with international capital flows. During the last two decades derivatives, as fiscal instruments, experienced enormous growth and gained increasingly of importance. This is mainly due to their ability to allow the spreading of risks in cross border capital movements, making such investments more appealing and the diversification of portfolios more likely. Yet, derivative markets are “controversial because they are not well known outside a small group of specialists. Most people look at them with suspicion and focus on their role as highly effective instruments for speculation. And, indeed, given the leverage they provide, fortunes can be made or lost in the wink of an eye.”¹ Although derivatives do not ‘create’ anything, it will be shown in the course of this study that the importance of derivatives lies in the fact that they can be used to reduce, diversify and control uncertainty and risks associated with various corporate activities, thus creating substantial benefits as well as complexities. For that purpose, section one is going to define the most common derivative products before addressing their general purpose, followed by exemplifying two principal risks aligned with the use of derivatives, namely credit- and market risk. Subsequently this works is going to discuss the positive as well as the negative effects derivatives may have on banks and investors. Sections five, six and seven will then illuminate systematic predicaments, address risks and eventually conclude after having considered the entanglement and market share of derivatives. Warren Buffett, Forbes-listed as the richest person in the world, “has called credit derivatives ‘financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.’ Nominally they are insurances against defaults, but they encourage greater gambles and credit expansion, which are moral hazards”² whereas Alan Greenspan, on the other hand, observed that “derivatives have come to play an exceptionally important role in our financial system and in our economy. These instruments allow users to unbundle risks and allocate them to the investors most willing and able to use them.”³ Therefore, it is this study’s object to illuminate the complexity of derivatives and exemplify both, their advantageous and unfavourable but yet undeniably powerful characteristics.

1. Defining Derivatives

No matter whether derivatives are traded over the counter (OTC) or on exchange, they are very complex products which are hard to define. “Credit derivatives are negotiated in a decentralized, over the counter market, thus quantifying and documenting the market’s spectacular growth in recent years is no easy task.”⁴ They differ in application and content depicting “the principal instrument that speculative capital uses in the global marketplace. From the viewpoint of the market, they appear to be necessary and natural because they are motivated by the risks associated with the connectivites lying at the heart of globalization.”⁵ Initially derivatives were mainly traded publicly whereas nowadays, approximately eighty percent of the market is traded over the counter. As illustrated in the chart below, the OTC market has grown continuously and decreased only in 2008 as a result of reduced market activity after the global credit crunch.

Source: Bank of International Settlements (BIS)

illustration not visible in this excerpt

Exchange traded contracts are standardised contracts whereas OTC derivative markets offer customized and more flexible products. Yet, they have ample common features allowing them to be described as fiscal instruments with structures and characteristics that refer to financially significant external items. As such, derivatives originate from external items, often called underlyings, which define their intrinsic value as tradable assets. Underlying assets or market variables can range from cash, stocks and bonds to tangibles or intangibles like currency rates, credit quality or interest rates. “A credit derivative is a financial instrument whose value is derived from an underlying market variable reflecting the credit risk of a public or private entity. The objective of credit derivatives is to isolate and price the credit risk from an underlying instrument.”⁶ Thus, the value of the derivative depends substantially on the quality of its underlying asset which demonstrates its nature as an obligation or right, rather than a tradable product. It is this obligation or right that obtains the derivative’s value, like a real asset, allowing it to be traded. Therefore, derivative products are formed by contracts that may be implemented by physical- or cash settlements. If one party is required to buy or sell the underlying it would be a physical settlement whereas it would comprise a cash settlement if just an equivalent to the underlying is bought or sold, merely simulating a physical exchange, without moving the actual underlying asset.

Derivatives account for a substantial amount of the global fiscal system with a variety of forms continuously developing and adapting. Despite the perpetual expansion of exotic derivative products the most common derivatives consist mainly of futures, forwards, options and swaps. However, structured notes constitute highly leveraged commodities with their notional value commonly underestimating the dimension of the risk taken. Therefore, this study is going to give only a brief exemplification of the most common financial products before addressing the general purpose and benefits of derivative instruments.

i. Futures

Futures are exchange trade contracts generally calling for delivery of a specified amount of a particular financial instrument at a fixed date in the future. They are highly standardised and traders only need to agree on the price and number of contracts traded.

ii. Forwards

Forwards are transactions with two parties agreeing to exchange a specified

amount of one currency for a specified amount of another under agreed conditions at some future time.

iii. Options

An option is a contractual right and no obligation to buy (call) or sell (put) a specified amount of the underlying security at a certain price before or at a particular date in the future.

iv. Swaps

Swaps are financial transactions in which two parties agree to exchange payments over time according to a predetermined rule. A swap is commonly used to transform the market exposure associated with a loan (either fixed or floating) or currency of one denomination to another.

v. Structured Note

Structured notes require, similar to the purchase of standard bonds, the delivery of a fixed amount of principal by the buyer to the seller. They are the combination of a derivative, such as an option or future, with a credit market instrument, like a bond or note. Structured notes frequently offer the investor and issuer better yields and better combinations of risk characteristics than comparably rated securities.

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¹ Steinherr, Alfred. Derivatives. The Wild Beast of Finance. p.101

² Kolko, G. An economy of buccaneers and fanasists. Weapons of mass financial destruction. “Le Monde Diplomatique”

³ Bryan, Dick. Rafferty, Michael. Capitalism with Derivatives. p.61

⁴ Bomfim, Antulio. Understandin Credit Derivatives and Related Instruments. p.17

⁵ LiPuma E. and Lee B. Financial derivatives and the rise of circulation. “Economy and Society” 34:3 2005, August / p.407

⁶ Steinherr, Alfred. Derivatives. The Wild Beast of Finance. p.164