Investment Management. Financial Crisis and Derivatives

FROM THE 1970s to the early 1990s, CERTAIN FINANCIAL SECCTOR DEVELOPMENT TOOK PLACE WHICH PRECIPITATED THE EMERGENCY OF ‘’Financial Derivatives’’. THESE FINANCIAL DERIVATIVES AIMED AT HELPING MANAGERS OF FINANCIAL INSTITUTIONS TO REDUCE THE RISK OF DOING THEIR BUSINESS.

You are required to discuss this financial development and write short but precise note on any four of the financial derivatives that you studied.

To start with, the need and sole contributor to financial sector development revolves around financial crisis. The term financial crisis is implied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their values. Financial crises have been an unfortunate part of the industry since its beginnings. Bankers and financiers readily admit that in business so large, so global and so complex, it is naive to think such events can ever be avoided.

A brief look at a number of financial crises over the last 30 years suggests a high degree of commonality: excessive exuberance, poor regulatory oversight, dodgy accounting, herd mentalities and, in many cases a sense of infallibility. William Rhodes has been involved in the industry for more than 50 years and has lived through nearly every modern-day financial crisis, many of which are detailed in his book, ‘’Banker to the world’’. As he puts it, there is a common theme of countries and markets wanting to believe that they are different and that they as not as connected to the rest of the world’s economy. In his view, many aspects of the Latin American debt crisis of 1982 have been repeated a number of times and there is much from this crisis which we can apply to what is currently in Europe, Africa and beyond.

For this term paper, we are going to highlight few with brief narration:

LatAm sovereign debt crisis - 1982

This crisis developed when Latin American countries, which had been gorging on cheap foreign debts for years, suddenly realised they could not repay it. The main culprits, Mexico, Brazil and Argentina, borrowed money for development and infrastructure programmes. Their economies were booming, and banks were happy to provide loans to the point where Latin American debt quadrupled in seven years. When the world’s economy went into recession 1970s the problem compounded itself. Interest rate on bond payments rose while Latin America currencies plummeted. The crisis officially kicked off in august, 1982 when Mexico’s finance minister Jesus Silva­Herzog said the country could not pay its bills. Rhodes recalls it as a tense period, but says that strong political leadership enable them to get through the crisis. He laments, however, that the lessons of the crisis weren’t heeded.

Savings and Loans crisis- 1980s

While the solution to the Latin American crisis was being put together, a domestic one was happening right in front of the United States regulators. The so-called savings and loans took place throughout the 1980s and even into the early 1990s when more than 700 savings and loan associations in the US went bust. These institutions were lending long term at fixed rate using short term money. As interest rate rose, many became insolvent. But thanks to a steady stream of deregulation under President Ronald Reagan, many firms were able to use accounting gimmicks to make them appear solvent. In a sense, many of them resembled Ponzi schemes. The government regulated with a set of regulations called the Financial Institutions Reform, Recovery and Enforcement Act of 1989. While the act tightened the rules on S&Ls, it also gave Freddie Mac and Fannie Mae more responsibility for supporting mortgages for lower- income individuals.

Stock Market Crash - 1987

Despite the shock of the savings and loan crisis, two more crises took place before the 1989 Act. The most memorable was the 1987 stock market crash. On what became known as black Monday, global stock markets crashed, including in the US, where the Dow Jones index lost 508 points or 23% of its value. The causes are still debated. Much blame has been placed on the growth of programme trading, where computers were executing a high number of trades in rapid fashion. Many were programmed to sell as prices dropped, creating something of a self-inflicted crash.

And other crises like: Junk Bond Crash-1989, Tequila Crisis-1994, Asia Crisis-1997/98 and Dotcom Bubble-1999 to 2000 etc.

To crown it all, below are few highlighted types and causes and consequences of financial crises:

- Banking crises ( Bank run and Credit crunch)
- Speculative bubbles and crashes (Stock market crash and Bubble/economics)
- International crises (Currency crisis, capital flight and sovereign default)
- Wider Economic crises (Recession and Depression/economics)

Causes and Consequences:

- Strategic complementarities in financial markets
- Leverage-borrowing to Finance investments
- Asset-liability mismatch
- Regulatory failures
- Fraud
- Contagion/system risk
- CEcopathy

See also brief illustration of ‘’The Demise of the Golden Age’’

In the 1970s, the United States’ position as the unchallenged colossus of the capitalist world was suddenly threatened from multiple directions: rising international competition, spiking energy prices, declining productivity and profitability, and soaring inflation and unemployment. The United States’ trade deficit crept up in the course of 1960s, and government deficits emerged late in the decade and persisted through the 1970s. Declining international confidence in the dollar led to the depletion of the U.S. government gold reserves, as international holders of dollars demanded redemption of their dollars for gold. (The Nixon administration responded by ending the fixed-rate convertibility of the dollar for gold.) Inflation picked up in the late 1960s, racketing up from about 3% in 1966 to nearly 6% in 1971. While these rates may not look that high now, they were alarming at the time, coming on the hills of a seven year period in which the annual inflation rate never exceeded 1.6% (Nixon responded to the threat of inflation with unprecedented peacetime wage and price controls). In 1973-1974, the first of two major ‘’oil shocking” increased the price of petroleum four-fold, dramatically raising energy costs for both consumers and businesses. Workers wage demands outpaced the rate of productivity growth, driving up unit labour costs for businesses. The annual inflation rate spiked to over 10% in 1974 and again in each of the three years from 1979 to

1981. The annual unemployment rate topped 8% in 1975 and would reach nearly 10% in 1982.

The shift in policies differed in timing, content, and speed from country to country and included many reversals. Broadly:

- African countries turned to financial liberalization in the 1990s, often in the context of stabilization and reform programs supported by the International Monetary Fund and World Bank, as the costs of financial repression became clear.
- In East Asia, the major countries liberalized in the 1980s, though at different times and to different degrees. For example, Indonesia, which had liberalized capital flows in 1970, liberalized interest rates in 1984, but the Republic of Korea did not liberalize interest rates formally until 1992. Low inflation generally kept East Asian interest rates reasonable in real terms, however. In most countries, connected lending within industrial-financial conglomerates and government pressures on credit allocation remained important.
- In South Asia, financial repression began in the 1970s with the nationalization of banks in India (1969) and Pakistan (1974). Interest rates and directed credit controls were subsequently imposed and tightened, but for much of the 1970s and 1980s real interest rates remained reasonable. Liberalization started in the early 1990s with a gradual freeing of interest rates; a reduction in reserve, liquidity, and directed credit requirements; and liberalization of equity markets.
- In Latin America, episodes of financial liberalization occurred in the 1970s but financial repression returned, continued, or even increased in the 1980s, with debt crises, high inflation, government deficits, and the growth of populism (Dornbusch and Edwards 1991). In the 1990s, substantial financial development occurred, although the degree and timing varied across countries.
- In the transition economies, financial liberalization took place fairly rapidly in the 1990s in the context of the reaction against communism (Bokros, Fleming, and Votava 2001; Sheriff, Borish, and Gross 2003).

The earliest policy changes generally focused on interest rates. In many instances governments raised interest rates with a “stroke of the pen” to mobilize more of the resources needed to finance budget deficits and to enable the private sector to play a greater role in development. (Some interest rate increases, designed to curb capital flight, were intended more for stabilization than for liberalization.) New financial instruments were introduced that had freer rates and were subject to lower directed credit requirements.

In response to the reduction of such financial crises and risks managers of financial institutions became more alert to financial innovations by the introduction of new financial instruments to better control and manage the risks and crises they faced.

In the last 25 years derivatives have become increasingly important in the world of finance. Futures and options are now traded actively on many exchanges throughout the world.” (Hull 2006, p. 1)

Mishkin (2006) is even more adamant that derivatives are new financial instruments that were invented in the 1970s. He suggests that an increase in the volatility of financial markets created a demand for hedging instruments that were used by financial institutions to manage risk.

Does he really believe that financial markets were insufficiently volatile to warrant derivative trading before the 1970s?

Starting in the 1970s and increasingly in the 1980s and 90s, the world became a riskier place for the financial institutions described in this part of the book. Swings in interest rates widened, and the bond and stock markets went through some episodes of increased volatility. As a result of these developments, managers of financial institutions became more concerned with reducing the risk their institutions faced. Given the greater demand for risk reduction, the process of financial innovation described in Chapter 9 came to the rescue by producing new financial instruments that helped financial institution managers manage risk better. These instruments, called derivatives, have payoffs that are linked to previously issued securities and are extremely useful risk reduction tools.” (Mishkin, 2006, p. 309)

The widespread ignorance concerning the history of derivatives is explained by a dearth of research on the history of derivative trading. Even economic historians are not well informed about the long history of derivative markets. A review of three leading economic history journals - the Journal of Economic History, the Economic History Review and the European Review of Economic History - has yielded not a single article after 1990 with a title that would indicate that it deals with some aspect of the history of derivative securities. Similarly, the Oxford Encyclopaedia of Economic History (2003) gives short shrift to derivative markets; it includes an entry on commodity futures in the United States in the nineteenth century and options are shortly mentioned in the entry on the stock market. At the moment, articles on the history of derivatives can be found only in working papers and edited volumes. Goetzmann and Rouwenhorst (2005) includes an article by Gelderblom and Jonker on derivative trading in Amsterdam from 1550 to 1650, and two volumes edited by Poitras (2006/2007) contain the so far most comprehensive collection of articles and sources on derivative markets during the past four hundred years.

The history of derivatives has remained unexplored because there are few historical records of derivative dealings. Derivatives left no paper trail because they are private agreements that have been traded in over-the-counter markets for most of their history. Even today, the international commodity and financial markets, which have always been a primary focus of derivative dealings, remain beyond the reach of national statistical offices. Another reason why historical records of derivatives are scant is conceptual. A forward contract has no market value when it is set up, although its notional value may be large. Thus, how should a forward contract be recorded when it is set up? There is naturally no point in recording a zero value. This problem is even more acute with futures contracts whose market value does not deviate much from zero during their entire life. At the end of each day, the value of a futures contract is set back to zero by crediting or debiting the daily change in value to a margin account. The Triennial Central Bank Survey of the Bank for International Settlements, which was first published in 1989, for the first time addressed the conceptual and practical difficulties of recording derivative dealings in international over-the-counter markets.

Summary of Derivative Markets

Derivatives are used generally to cover an asset or security rather than one issued by business or government to raise capital. It is used to cover any asset that is not a primary asset. In other words, any financial instrument whose value today or at a future date is derived entirely from the value of another asset or a group of other assets. These other assets are called a primary asset, a primitive asset or an underlying asset. Basic derivatives are Futures, Forwards, Swaps, Options, Structured notes, and Real Estates. We can have different variations of these, such as interest rate, future contract, options on futures, mortgage backed securities, swap options and, commodity linked bonds. Variations of the basic derivatives cover all sorts of options contractual arrangements and relate the value of other primitive securities. From the above, one can conclude that any asset that is not a primary asset such as stocks and bonds is a derivative asset.

Today, the introduction of these new instruments often referred to as Financial Derivatives have pay-offs that are linked to securities previously issued.

Financial derivatives

These are financial instruments that are linked to a specific financial instrument or indicator or commodity, and through which specific financial risks can be traded in financial markets in their own right. Transactions in financial derivatives should be treated as separate transactions rather than as integral parts of the value of underlying transactions to which they may be linked. The value of a financial derivative derives from the price of an underlying item, such as an asset or index. Unlike debt instruments, no principal amount is advanced to be repaid and no investment income accrues. Financial derivatives are used for a number of purposes including risk management, hedging, arbitrage between markets, and speculation.

The most vital financial instruments that managers of financial institutions normally used in their various markets to minimize such risk include:

1. Forward contracts
2. Financial options
3. Financial swaps contract
4. Financial future contract

1. FORWARD CONTRACTS:

A forward contract is an unconditional financial contract that represents an obligation for settlement on a specified date. At the inception of the contract, risk exposures of equal market value are exchanged. Both parties are potential debtors, but a debtor/creditor relationship can be established only after the contract goes into effect. Thus, at inception, the contract has zero value. However, during the life of a forward contract, the market value of each party’s risk exposure may differ from the zero market values at the inception of the contract as the price of the underlying item changes. When this occurs, an asset (creditor) position is created for one party and a liability (debtor) position for the other. The debtor/creditor relationship may change both in magnitude and direction over the life of the forward contract. Forward contract is a non-standardized contract between two parties to buy or sell an asset at a specified time at an agreed price.

Some Merits of forward contracts are as follows:

- The use of forwards provide price protection
- They can be matched against the time period of exposure as well as for the cash size of the exposure.
- Forwards are tailor made and can be written for any amount and term.
- They can be as flexible as the concerned parties want them to be.
- They are easy to understand and are over-the-counter products.
Demerits of Forward Contracts are as follows:
- It is subject to default risk
- Even where counterparty is found one party may not get as high a price it wants for lack a willing partner i.e. this market lacks liquidity.
- It requires trying up capital. There are no intermediate cash flows before settlement.
- It may be very difficult to find a counterparty to make the contract with even where brokers exist to facilitate the process.

2. FINANCIAL OPTIONS:

These are derivatives contracts and another way for hedging interest rates and stock market risks on financial instruments. Option gives the right but not the obligation to buy or sell an asset at a set price on or before a given date i.e. call or put options. It is also a contract in which the writer (seller) promise that the contract buyer has the right, but not the obligation, to buy or sell a certain security at a certain price (the strike price) on or before a certain exercise or expiration date. The owner or buyer of an option doesn’t have to exercise the option he or she can let the option expire without using it. An identification of two types of options is:

a. American Option which can be exercise at any time up to the expiration date of the contract and,
b. European Options which can be exercise only on the expiration date.

Merits of trading in options:

- Options allow you to employ considerable leverage. This is an advantage to disciplined traders who know how to use leverage
- Some strategies like buying options, allows you to have unlimited upside with limited downside.
- Options allow you to create unique strategies to take advantage of different characteristics of the market - like volatility and time decay.
- Options allow you to take a position with very low capital requirements. Someone can do a lot in the options market with $1,000 but not so much in the stock market.
Demerits of trading in options:
- Many individual stock options don’t have much volume at all. The fact that each option able stock will have options trading at different strike prices and expirations means that the particular option you are trading will be very low volume unless it is one of the most popular stocks or stock indexes.
- Options tend to have higher spreads because of the lack of liquidity. This means it will cost you more indirect costs when doing an option trade because you will be giving up the spread when you trade.

Options are very complicated to beginners. Most beginners, and even some advanced investors, think they understand them when they don’t.

- When buying options, you lose the time value of the options as you hold them. There are no exceptions to this rule.

3. FINANCIAL SWAPS CONTRACT:

With the exclusion of forward, futures and options financial institutions use one other important financial derivative to manage risk i.e. SWAPS. A swap is a derivative contract through which two parties exchange financial instruments. These instruments can be almost anything, but most swaps involve cash flows based on a notional principal amount that both parties agree to. Also, there are two basic swaps that exist:

a) Interest Rate Swap: An Interest rate swap (IRS) is a liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified amount from a fixed rate or a floating rate (or vice versa) or from one floating rate to another. Below are some examples of interest rates swaps:

- The type of interest payment ( variable or fixed rate)
- The interest rate on the payment being exchange
- The time period over which the exchange continued to be paid

b) Currency swap: deals with the exchange of a set of payment in one currency for a set of payment in another currency.

Advantages of swaps

- Parties with informational advantages who to eliminate interest rate risk may suffer loss of information advantages
- It involves a substantial transaction cost when balance sheets are rearranged

Disadvantages of swaps

They are subject to the same default risks connected with forward contract thus leading to considerable loss on one side - Swap markets, like forward market may suffer from lack of liquidity

4. FINANCIAL FUTURE CONTRACT S:

Given the default risk and liquidity problems of interest rates forward markets, the financial futures contract was developed by the Chicago Board of trade in 1975 this was to solve the problem of hedging against interest rate risks. A futures contract is a contractual agreement, generally made on the trading floor of a futures exchange to buy or sell a particular commodity or financial instrument at a pre-determine price in the future.

Merits/advantages of trading financial futures contract

- The commission charges for futures trading are relatively small as compared to other type of investments.
- Futures contract are highly leveraged financial instrument which permit achieving greater gains using a limited amount of invested funds
- It is possible to open short as well as long positions. Position can be reversed easily
- Lead to high liquidity
Disadvantages of trading financial futures contract
- Leverage can make trading in future contract highly risky for a particular strategy
- Future contract is a standardised product and written for fixed amount and terms
- Lower commission costs can encourage a trader to take additional trades and lead to over trading
- It is subject to basis risks which is associated with imperfect hedging using future

References:

- Financial Derivatives

Prepared by Statistics Department - International Monetary Fund (IMF)

- Mishkin Fredrick S. (2000) - The Ec0n0mics of money, Banking and Financial Markets

6th Edition updated.

Addison Wesley, World student services.

- A short history of Derivative Security Markets

By Ernst Juerg Weber

The University of Western Australia

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