As the author has highlighted in the previous chapter, derivatives have come under wide criticism for their supposedly destructive nature in the financial markets and the effects of this spilling into the real economy (Sharma, 2008). McClintock, 1996 notes that derivatives are widely perceived as financial instruments that have led to financial losses or failures of firms. Moreover, he states that, it is believed that their (derivatives) market has brought increased international financial fragility to the global economy. Together with transactions that were once heralded as hallmarks of market efficiency (Kojima, 1995), such as conglomerate mergers (Lewellen, 1971), leveraged buyouts (Jensen, 1989), and junk bond offerings (Andersen, 1995), derivatives have been receiving mixed reaction from the public, frightened of the firm-specific risks and the systemic risks.
The firm-specific-risks, are composed of the credit, legal, market, liquidity, and management risks, whereas the systemic risks, involve that of greater competition between banks and non-bank financial institutions, greater interconnectedness of financial markets, increasing concentration of derivatives trading, the reduced disclosure of financial information through off-balance sheet activities, and increased market disturbances due to financial and telecommunication innovations (Becketti, 1995).
There have been strong debates, on the reasons why derivatives should exist and several arguments by theorists against the role of derivatives. Even their purpose of existence has been criticised (Dodd, 2002). The author therefore feels that it is necessary to understand the reasons for which derivatives have come into existence in the financial economy and their prevailing nature throughout the decades of developments in the global financial economy (Steinherr, 2002).
Therefore, this chapter sets the background and theory for the study, by highlighting literature on derivative use, their impact, noting characteristics of derivatives users and controllers and their perceptions, explaining the challenges of safe derivative use and summarising the cases reviewed.
Section 2.1 Derivatives and Their Use
Evolving need for derivatives
Chris Gaffney (2009) notes, that the global financial markets have evolved manifolds. In fact he explains that, the US and its currency are dominating the world financial markets, but nations similar to that of London and Tokyo are rapidly becoming centres of primary securities issues and secondary market trading. In a similar fashion, investment banks, securities firms, and futures and options exchanges have been posing challenges to commercial banks and stock exchanges, which were once the dominant institutions. Furthermore, the once dominant onshore market, which was subject to strict regulation, has been overtaken by the offshore markets, which are subject to considerably less regulation (Gaffney 2009).
Other changes in the global financial markets include the collapse of the Bretton Woods Agreement on pegged exchange rates in the early 1970s and the unexpected collapse of pegged rates in many countries such as Mexico, Thailand, Korea, Russia, and Brazil in mid-1990s. These events put pressures on regulators, users and controllers to understand the responsibility of investment managers and corporate treasurers in taking adequate steps to measure and manage their financial and operational risks. Regulation and controls have been developing with the journey towards a single regulator in Europe and controls towards the Governance, Risk and Compliance (GRC) and the recommendations proposed by the Basle committee. The use of IT and e-commerce has not only changed the world as we knew it two decades ago but has also added to the expanding menu of financial management choices (Gaffney 2009).
Derivatives can be viewed as a socially constructed and need-driven innovation in the financial economy, with its roots well ingrained in the events and circumstances in the real economy (Sharma, 2008). As the transition from a dominant production economy to one of a financial economy, was taking shape during the late 1960s and 1970s, the need to control highly increased volatility and fluctuations due to inflation problems, currency problems, debt defaults, and many other factors according to Brenner (2002) were profoundly felt. This increased need for controls such as regulation, risk management and audits, has been noted in literature as being the main reason for the increased global use of derivatives (Brenner, 2002).
Derivatives
Derivatives, as explained in the first chapter, are financial contracts, which "value depends on the values of one or more underlying assets or indexes" (Adams and Runkle, 2000). However, Peter Hancock, head of Global Derivatives at J.P. Morgan, explains rather inaccurately, "derivatives...seem to have come to mean anything that lost money" (Muehring, 1995: 21). Philippe Jorion in his book 'Big Bets Gone Bad' (1995) noted that derivatives have been portrayed as "monster creatures" to be feared and chained. Indicating that this is no doubt due to the volume of trading in them and reflects a mystique of complexity and danger attached to them. Backstrand (1997) on the other hand, illustrated a more formal definition of a derivative depicting it as a financial instrument, or contract, between two parties that derives its value from some other underlying asset or underlying reference price, interest rate, or index.
Philippe Jorion, in the same book noted above (1995), notes that there are well over hundred varieties of derivatives, many with difficult names. He notes some of these as caps, diffs, floors, swaptions, inverse floaters, knock-outs, step-ups and binaries. He indicates that the development in IT, modern microelectronics and software were the tools that have allowed mathematicians and even physicists create some highly sophisticated financial instruments. They are also hidden in mortgages and in debt instruments called structured notes. However, in their purest (plain vanilla) form as we shall see below, derivatives include forward contracts, futures, swaps and options.
Derivatives allow firms and government entities "to identify, isolate, and manage the market risks in financial instruments and commodities, separately." This is the reason why firms are increasingly relying on derivatives activities as "a direct source of revenue through market-making functions, position taking, and risk arbitrage" (Basel Committee on Banking Supervision, 1994). These financial instruments can be further categorised into exchange-traded, with an actual physical location where all trades occur and over-the-counter (OTC), which are traded over a decentralised network of Banks or Financial Institutions. All futures and many options contracts have been standardised and are traded on established exchanges (Romano, 1996), whereas forwards, swaps, and some options are custom-tailored contracts (Goldman, 1995).
Hedging is also considered as one of the uses of these instruments (Adams & Runkle, 2000) and a transaction involving this, aims to reduce the risk of economic loss due to changes in the value, yield, price, cash flow or quantity of assets or liabilities (Dembeck and Lim, 1999). Hedging is an activity to mitigate economic risk through the use of a negatively correlated investment (Frederick, 1995). It requires an end-user to identify specific business assets subject to price fluctuations and then to purchase derivatives that counteract the effects of a change in the price of those assets, thus ensuring compensating gains for losses caused by underlying market movements (Goldman, 1995).
A forward contract, is an agreement between two parties in buying or selling an underlying asset at a specified price and future date (Goldman, 1995), in which the buyer is obligated to purchase the underlying asset from the seller at the contract's maturity date and the seller must sell the asset to the buyer at the agreed-upon price regardless of current fair market value (Romano, 1996). These contracts are typically traded OTC, they are tailored to the needs of the client and are generally held till expiry Jorion (1995). A forward contract can be used to lock in a price in the future. For example a U.S. exporter to Malta, might have agreed to take payment in Euro for shipment of goods in 1 year. This exposes him to the risk that the dollar value of Euro will fall. Therefore, the Exporter can hedge this risk by taking a forward sale of Euro, Jorion (1995). Futures contracts differ in that they are standardised and must be traded on an organised exchange, providing a central location where buyers and sellers of standardised contracts trade (General Accounting Office Report, 1994). Thus, it is easier for a trader to close out a futures position than a forward position (Eatwell, Milgate, and Newman, 1998).
Another related type of instrument is the options contract, which is similar to both futures and forwards in the sense that each instrument draws its value from the future price of the underlying asset. These contracts also involve the future purchase or sale of an asset for a predetermined price (Frederick, 1995). Compared to the first two contracts, options contracts provide the holder the right, but not the obligation, to perform a specified transaction with another party. Options contracts are favoured over other types of derivative instruments because they mitigate the downside risks without foregoing upside potential (Adams & Runkle, 2000). Options to buy are called 'call options' and options to sell are called 'put options'. Since options confer the right and not the obligation, they will be exercised only if they generate profits. They can be traded both OTC and on exchange (Jorion, 1995).
Finally, swaps refer to OTC agreements between two parties to exchange a series of cash flows (Romano, 1996). A common type of this agreement is an interest rate swap (Puleo, 1987). This reduces the effect of interest rate volatility faced by both parties (Frederick, 1995). Compared with futures contracts, swaps are more beneficial because of the fact that they may be OTC and thus are not constrained by the standardisation requirements imposed on the futures market. Regarding hedging, swaps are most effective when the investor is a financial institution because financial institutions often possess "mismatched asset and liability" time frames (Romano, 1996: 65). Returning to the example of the US exporter noted above, he might arrange to pay a fixed amount of Euro every six months for the next five years in return for a fixed stream of receipts in dollars (Jorion, 1995).
` In the last decades derivative pricing and techniques have become quite sophisticated. The first option pricing model was offered by Louis Bachelier, a French mathematician in the 1900. Paul Samuelson introduced less practical improvements, due to the involvement of unknown parameters, in the late 1960s. However, a major breakthrough came in the early 1970s, with Fisher Black and Myron Scholes, who devised a rigorous yet flexible method for pricing options which is by now familiar to all option traders and scholars. This has been described as "the most successful model in applied economics." (Jorion, 1995).
Then why do derivatives matter? Why are they so important? Why do we need them? It is not the merely the size of the activity, but the role it plays in fostering new ways to understand, measure and manage financial risk. Through derivatives, the complex risks that are bound together in traditional instruments can be teased apart and managed independently and sometimes more efficiently (Global Derivatives Study Group, 1992).
In fact, Merton Miller (1994) in his article 'do we really need more regulation of financial derivatives?' notes that:
Their use has grown, I insist, because they have satisfied an important business need; they have allowed firms and banks, at long last, to manage effectively and at low cost business and financial risks that have plagued them for decades, if not for centuries.
Derivatives can save costs, increase returns and reduce risk of losses for many institutions and firms, while broadening the range of funding and investment alternatives. For others they can be a source of strength since they reinforce existing activities with clients, helping them to build diversified credit portfolios (Global Derivatives Study Group, 1992).
The benefits of using derivatives?
Derivatives have enjoyed a considerable amount of attention, being labelled as among investments that are surrounded by controversies. There are a significant number of examples of investors, who have failed because of their use. These events led to what Adams and Runkle describe as a kind of "derivaphobia." However, although there is strong criticism against derivatives, there are individuals who argue for their use in particular cases in order to mitigate possible losses (Aalberts and Poon 2006). They are flexible and can be used in many ways, in relation to the price of commodities, interest rates, exchange rates, and prices of equity and they help in stabilising the economy through the reduction of the enterprises that go under because of the volatility in the market.
The fast growth in derivatives has been enabled by the sophisticated nature of the present international markets. Knowledgeable investors can derive profits using this instrument through alterations in interest rates and equity markets in different countries, shifts in the exchange rate of currencies, and alterations in the supply and demand for commodities in the global scene (CFA, 2009).
There are several outcomes that can be achieved when some of the different forms of derivative instruments are added to the conventional contents of a portfolio of investments. These outcomes include a variation in the global instruments used in financial instruments and currencies, availability of a hedge for inflation and deflation, and earning of profit through investments that are not correlated with traditional investments (CFA, 2009). Price discovery and risk management are the two most common benefits that attributable to derivatives (CFA, 2009).
Price Discovery
The market price for futures relies on the flow of data from different parts of the globe and demands a high level of transparency (CFA, 2009). There are several factors that have an effect on the supply and demand for assets (particularly commodities), which also influence the present and future price of underlying assets on which the derivative contracts are based (CFA, 2009). The said factors include geographical conditions, climatic conditions, politics, environmental health, debt default, refugee displacement, land reclamation and others of the same sort (CFA, 2009). This information and the manner through which people see this, is the source that changes the prices of commodities, and is a process termed as price discovery (CFA, 2009).
In some of the future markets, the underlying assets could be placed in different geographical areas having different current/spot prices. The contract with the shortest time to expiration is often used as the substitute for the said underlying asset (CFA, 2009).
Moreover, the price of the future contracts serve as prices that can be accepted by those who engage in trading the contract instead of taking the risk associated with the uncertainty of future prices (CFA, 2009).
Options help in the process of price discovery through the way participants perceive the volatility of markets. Options serve as hedges for the investors since it protects them from the losses while allowing them the ability to gain in the assets (CFA, 2009).
Risk Management (risk shifting)
Risk management is considered as the most important goal that derivatives intend to achieve. It is defined as the process, which involves identification of the ideal risk level, identification of the existent risk level, and transforming the actual to the ideal level of risk. It is categorised within "hedging and speculation" (CFA, 2009).
Hedging is defined as the manner of decreasing the level of risk in holding a market position. Speculation on the other hand is taking a position vis-à-vis the movement of markets. However, strategies of hedging and speculation together with derivatives are seen as useful tools and techniques, which companies can use in order to manage risk more effectively (CFA, 2009).
They Improve Market Efficiency for the Underlying Asset:
For example, when an investor wishes to have an exposure to an S&P 500, he/she can purchase the S&P stock index fund or imitates it through purchasing futures and making investments in bonds that are risk-free (CFA, 2009). This strategy would provide the investor with the exposure to the index without the need for purchasing the underlying assets.
The decision of investors is neutral when the cost of purchasing through the strategies mentioned above is the same. However, when the prices are not the same, the investors decide to sell the more lucrative asset and purchase the less expensive one until there is equilibrium. In doing so, market efficiency is achieved.
Thus, in this manner, the derivatives help in reducing the costs of transactions in the market because it serves as insurance or a manner for managing risks. Due to their use as insurance and as a risk-management tool, the costs become lower or the investors will not see it wise to purchase "insurance" for the positions they hold.
Consequences of misusing derivatives?
While derivatives, as noted above play a positive role in the economy, their enlarged presence also pose potentially negative consequences, rising concerns regarding the capability, susceptibility, and efficiency of both the entire economy and the financial system (Dodd, 2002). These concerns are classified into two, those termed as "abuse of derivatives" and the others as "negative consequences" (Dodd, 2002). The last of the two serves as a threat to the credibility of the markets and the information included within the prices (Dodd, 2002). This since there is a lower level of trust and confidence in the markets of finances and commodities, because the capital costs are higher and because of the reduced market efficiency due to market prices distortion or threat of distortion (Dodd, 2002). The second category of "abuse," looks at the problems brought about by:
the acts of fraud and manipulation of market,
evasion of the payment of taxes,
the manipulation of the information regarding the balance of payments that a country has,
the income of the firm or the balance sheet, and
the expectations for the devaluation of the currency of a country (Dodd, 2002).
This type of abuse increases both risks that are systemic and contagion and provides the possibility of becoming an agitator for the crisis encountered in the financial system, which poses a threat to the stability of the financial economy (Dodd, 2002). It includes negative outcomes that arise in using derivatives for hedging or for the management of risk (Dodd, 2002). Moreover, the existence of derivative markets that are not properly regulated and poorly structured leads to the creation of new risks, new levels of risks, and new susceptibilities that affect the whole economy (Dodd, 2002).
Despite the ability of individual investors and firms to use this financial instrument for hedging purposes, by diverting it from those who have the least capabilities of handling the risk to those who are able and have the willingness, the whole financial system still incurs risk through this activity and the outstanding contracts made (Dodd, 2002). The argument in favour of or against the use of derivatives many times boils down to deciding on: the costs of negative consequences of derivatives versus the benefits of hedging (Dodd, 2002). However, it is seen that it is better to pinpoint and evaluate the source of these costs that subsequently enables the reduction through regulation (Dodd, 2002).
In the article mentioned above Miller (1994) continues to note that he has carefully phrased that there are 'no derivatives induced financial collapses' and that firms will continue to lose money on bad judgment and bad derivatives deals, exactly as they have done with other investments. He continues by saying that:
A major crack in one of the world's financial markets is always possible. But crashes in financial markets are not exogenous calamities like earth quakes. They are policy disasters, tracing not to transactions between private-sector parties but to the deliberately deflationary actions of a central bank somewhere, usually one overreacting to its previous policy errors in the other direction.
Abuse
Derivatives are also used to protect the efforts of the investors in managing the risk from abuse and fraud (Dodd, 2002). This is a sensitive issue since it includes commitments/contracts that last for a specific period of time (Dodd, 2002). Where a market characterised to be cash-and-carry is capable of self-regulation, the dimension of time does not allow for this to be noticed immediately and allows for the involved to get away (Dodd, 2002). Likewise, the financial world gives value to time making the impact of loss greater (Dodd, 2002). Another factor is the distance of the different actors in the transactions where oftentimes, they are in different areas. The separation of space and time makes it easier to commit fraud without being noticed immediately (Dodd, 2002). In fact because of these separations, transactions involving derivatives are often beset with "sharp," "misleading," "false promise of returns," or other "boiler room" activities (Dodd, 2002). Likewise, unfair or fraudulent derivative trading practices such as "fictitious trading," "wash trades," inappropriate use of market information, and "front running" also result (Dodd, 2002). Engaging in these activities lead to investors losing a substantial part of the value of their investment positions and could impact on the efforts to manage risks (Dodd, 2002). This also leads firms and individuals to prevent in engaging in such (Dodd, 2002).
Manipulation
Manipulation is another factor that needs to be restrained in order to ensure the safe use of derivatives. Manipulation can take several forms, some of which, together with the outcomes of this in relation to the economy are noted below:
Information-based manipulation: This involves "insider trading" or the creation of false reports regarding the market. Where one uses information not disseminated to the market or disseminates false information for his/her benefit. This can be done if regulation does not require derivatives information to be disclosed (transparency reporting requirements) and if they are not captured in the regulation of prevention of market abuse (which includes market manipulation and insider dealing) (Dodd, 2002).
Action-based manipulation: This involves the intentional taking of some actions in order to alter the perception regarding the value of commodities and/or assets. Managers of a firm can for example short the firm's stock and later announce some bad news (eg. Loss of a major contract) so that they can buy the stock at a lower price and cover their short positions profitably. Derivatives especially OTC can facilitate this type of manipulation since they help to make the gains from such a price change and allow that a position is built up without it being detected completely (Dodd, 2002).
Trade-based manipulation: this involves the acquisition of a considerable quantity of a position in one market and gains from profits created out of the distortion in the prices in a related market. When done through OTC derivatives, it is not possible for the government or other market competitors to be able to determine the entire position of the one manipulating the market. For example, in order to increase the value of the long derivatives positions, a manipulator buys a substantial inventory from the spot-or-cash market for crude oil. The success of the manipulator depends on whether he is able to sell the said inventory without encountering problems that lead to losses. Noticeably, it is not required for the manipulator to acquire the entire inventory, but would only need a significant proportion of the whole to be able to influence the increase in the price (Dodd, 2002).
Manipulation is an act, which affects the interest of the public because of the impact it has on the integrity of the information derived from the price signals and the activities within the market. The price in the derivatives market is considered significant, because it has an impact on the producers and the consumers present in the economy. While not every derivatives market leads to price discovery, a significant amount of these occur. It can happen in markets where trade of derivatives occur in exchanges and in several OTC markets.
However, the knowledge pertaining to the price discovery in the dealer-based markets is limited to the major market participants and not the entire economy. This results in economic inefficiencies related to the non-equal distribution of the information provided, incidents of manipulation, and scandals that affect the cognition of the public regarding the derivatives market. It also has a corresponding impact on the market efficiency, trading volumes and market activity. Moreover, it decreases the liquidity and results in a higher cost for the risks (included in the negotiation price - priced into the bid-offer spread). As noted the credibility and confidence that investors place on the practices in trading and prices in the market effect the extent of derivatives use (Dodd, 2002).
Joseph Stiglitz (1998), World Bank's past chief economist, stated that, "The increased use of derivatives [in developing economies] is increasingly making the full disclosure of relevant information, or at least the full interpretation of the disclosed information, even more difficult" (as cited in Dodd, 2002: 14). Derivatives may lead to transparency problems because of the vagueness in using the definition of corporate income and balance sheets as an appraisal for the risk and profit that is associated with firms. It may take the form of falsely creating income and hiding debt incurred with the use of other financial instruments. The exposures that occur outside the balance sheet do not allow for the risk exposures, due to derivatives, to be completely visible and this alters, enlarges, or minimises the risk seen within the balance sheet (Dodd, 2002).
Dodd (2002) explains that despite the existence of formal accounting rules (in the US) and the regulations present in financial markets, a survey revealed that 42% of the total businesses in the US utilise derivatives in order to "manage reported earnings" by transferring the income from one period to another. Moreover, he continues to explain that this has not stopped the use of derivatives to fabricate income and hide debt. Thus leading to distorted market information, decreasing the ability of the firms to make appropriate evaluations of the creditworthiness of the other parties they transact with. More so, the inadequacy of the information and data available on OTC derivatives leaves regulatory authorities without any means of detecting manipulation in the respective markets (Dodd, 2002).
Thus, the regulatory authorities are unable to determine the outstanding positions of all or either the main participants in the financial sector, leaving them without any knowledge regarding the risk to which these financial markets are exposed to in relation to the available capital. The regulatory bodies, thus, have difficulties in monitoring the susceptibility of the economy to variations within the primary market factors such as interest and exchange rates (Dodd, 2002).
The unavailability of information for determining the risk also has an impact on the balance sheet of a nation. Thus, it can be said that the numbers used in order to assess the country's actual market risk exposure are, with the presence of derivatives, made less useful, if not misleading. This is because the related exposures of currency could increase or decrease considerably the positions from capital or foreign investments. The currency value of the assets and liabilities can be converted into foreign exchange derivatives. Moreover, the long-term loans can be transformed into short ones if related "put" options are exercised and there is also a possibility that the type of capital and the instrument of investment can be changed. Interest rate exposures on assets and liabilities can be changed using interest rate swaps and it is possible for short-term dollar loans to look like a portfolio of investments through total return swaps. Moreover, the need to meet the calls for margin or collateral on derivatives creates the tendency for a rush of large amounts of foreign exchange flows, which are not indicated in the quantity of foreign debt and securities in the balance of payments accounts of a particular nation (Dodd, 2002).
Similar dangers are encountered when the governments use derivatives to manage public debt. Dodd (2002) notes that although countries have used derivatives to lower borrowing only Sweden has been singled out as having done this while maintaining transparency of their market. He continues to note that a study sponsored by the International Securities Market Association authored by Piga (2001), shows that at least one of the European countries intentionally misused derivatives to manoeuvre its debts cash flow reports to be able to reach the requirements of the Maastricht deficit target criteria in 1997 (Dodd, 2002).
David Nussbaum (1977) states that among the most important challenges that the IMF are facing because of this widening of derivatives, is the restructuring of the systems by which its member countries account for the balance of payments (Dodd, 2002). He refers to the statement by David Folkerts-Landau that "cross-country derivatives positions have played havoc with the balance of payments data" and "one internal [IMF] estimate has off-balance positions potentially warping emerging market economic data by as much as 25%". To this effect, there is a strong call for countries to maintain transparency in their use of derivatives to manage their debt and to include this as a high policy priority (Landau, 1987; Cassard and Folerts-Landau, 1997 in Dodd, 2002).
