Evolution of derivatives market


In line with the objectives of the study, this part of the dissertation paper makes a detailed review of the available literature on the evolution of the derivatives market and to what extent they have fulfilled their functions in the economy generally. Whether or not derivatives have been beneficial in general is a highly debatable topic and views differ among writers.

Financial globalization facilitates greater diversification of investment and enables risk to be transferred across national financial systems through derivatives. The consequential improvement in allocation of risks has made overall capital markets more efficient, while the availability of derivatives to both limit and leverage risk exposures has increased market capitalization and liquidity in the underlying cash markets. But emerging derivative markets also pose important challenges to financial stability, mainly in areas where vulnerabilities to changes in risk extend across institutions and national boundaries. Emerging market regulators recognize the necessary importance of developing derivatives markets; they remain concerned about potentially excessive risk-taking, particularly in the context of rapid evolution of products, inadequate understanding of risk management techniques, and limited supervisory capacity.

The impact of derivatives on financial markets represents a perspective that has its positive as well as negative points. Some authors like Keynes for instance who wrote about investors who practice the fourth, fifth and higher degrees of speculation, believe that "derivatives" is a fancy name for gambling. According to them speculative trading of derivative products has not fueled the rapid growth in their use and derivatives are not used merely to speculate on the direction of interest rates or currency exchange rates. Indeed, the explosive use of financial derivative products in recent years was brought about by three primary forces: more volatile markets, deregulation, and new technologies. Thus, derivatives were originally intended to be used to effectively hedge certain risks; and, in fact, that was the key that unlocked their explosive development.

History of derivatives market:

Modern textbooks in financial economics often tend to misrepresent the history of the derivatives market. For instance, Hull (2006) puts forth that derivatives became significant only during the past 25years and that it is only now that they are traded on exchanges. Mishkin (2006) was more specific and he declared that derivatives are new financial instruments that were invented in the 1970s and that this was a result of an increase in the volatility in financial markets that created a demand for hedging instruments to be used by financial institutions to deal with risks.

The history of derivatives is in fact traced back to the origins of commerce in Mesopotamia in the fourth millennium BC. After the collapse of the Roman Empire, contracts for the future delivery of commodities continued to be used in the Byzantine Empire in the Eastern Mediterranean and they survived in canon law in Western Europe. During the Renaissance, financial markets became more sophisticated in Italy and the Low Countries. Contracts for the future delivery of securities were used on a large scale for the first time in Antwerp and then Amsterdam in the sixteenth century. Derivative trading on securities spread from Amsterdam to England and France at the end of the seventeenth century, and from France to Germany in the early nineteenth century.

The first exchange for trading derivatives happened to be the Royal Exchange in London, which permitted forward contracting. The first "futures" contracts are generally traced to the Yodoya rice market in Osaka, Japan around 1650. These were evidently standardized contracts, which made them much like today's futures, although it is not known if the contracts were marked to market daily and/or had credit guarantees. The next major event, and the most significant as far as the history of U. S. futures markets, was the creation of the Chicago Board of Trade in 1848. This came up when farmers faced difficulties to store the enormous increase in supply that occurred following the Midwestern grain harvest. Chicago spot prices rose and fell drastically. A group of grain traders then created the "to-arrive" contract, which allowed farmers to lock in the price and deliver the grain later. The grain was either stored on the farm or at a storage facility nearby, to be delivered to Chicago months later. These to-arrive contracts proved useful as a device for hedging and speculating on price changes. The grain could always be sold and delivered anywhere else at any time. These contracts were eventually standardized around 1865. Profit charts made derivatives accessible to young scientists, including Louis Bachelier and Vinzenz Bronzin, who had the mathematical knowledge for the rigorous analysis of derivative pricing. Consequently in 1925, the first futures clearinghouse was formed.

The Chicago Board of Trade (CBOT), the largest derivative exchange in the world, was founded in 1848 where forward contracts on various commodities were standardized around 1865. From then on, futures contracts have remained more or less in the same form, as we know them today. In 1919, the Chicago Butter and Egg Board, a spin-off of CBOT, was reorganized to allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME). In April 1973, the Chicago Board of Options Exchange was set up specifically for trading in options. The markets for options developed so fast that by early 1980s the number of shares underlying the option contract sold each day exceeded the daily volume of shares traded on the New York Stock Exchange. There has been no looking back ever since.

Thus while a few commodity-based (e.g., agricultural) industries have a long history of hedging with exchange-traded derivatives, the use of derivatives has indeed grown remarkably since the introduction of foreign exchange and interest rate products in the 1970s. Derivatives are not really new products; they were indeed around before the time of Christ however it is as from the 1970s that they started gaining popularity.

Today the size of derivatives markets is enormous, and by some measures it exceeds that for bank lending, securities and insurance. Mirroring this growth is an increasing volume of research that seeks to understand the economic rationales for financial risk management. For example, financial theory suggests that corporate risk management is bound to increase firm value in the presence of capital market imperfections such as bankruptcy costs, a convex tax schedule (Smith and Stulz, 1985), or underinvestment problems (Bessembinder, 1991; Froot, Scharfstein, and Stein, 1993).

Despite these developments, derivatives seem to remain a rather exotic area that often puzzles the public, who has come to know about these derivatives largely through the reporting in the news media of cases involving large losses. These cases include Enron (Partnoy 2002), Barings PLC (Kuprianov 1995), and Procter & Gamble (Miller 1997). One of America's wealthiest localities, Orange County, California, declared bankruptcy, allegedly due to derivatives trading, but more accurately, due to the use of leverage in a portfolio of short- term Treasury securities. England's venerable Barings Bank declared bankruptcy due to speculative trading in futures contracts by a 28- year old clerk in its Singapore office. These and other large losses led to a huge outcry, sometimes against the instruments and sometimes against the firms that sold them. There was presumably nothing wrong with the techniques themselves, just the way in which they were used. It is sometimes argued that measures to improve the safety of car occupants, e.g. seat belts, increase risk by encouraging drivers to go faster than they would without them. While some trivial changes occurred in the way in which derivatives were sold, most firms simply established tighter controls and continued to use derivatives.

It is possible that the sophisticated models that apparently enable risk to be accurately quantified encourage risk taking by financiers who would otherwise err on the side of caution. However that does not explain other scandals that have involved derivatives. Lots of economists warned about the dangers associated with derivatives and Sir Julian Hodge was one of the first to do so. The complexity of derivatives and the need for transparency in their reporting have led to several serious debates, the most recent being the collapse of AIG and the 2008 credit crisis in the UK.

Definition of derivatives

Derivatives are financial contracts on a pre-determined payoff structure, whose value derive from underlying assets, such as securities, commodities, market indices, interest rates, or foreign exchange rates. Derivatives have three main economic functions namely:

  1. risk management whereby the derivatives provide a mechanism through which investors, corporations, and countries can efficiently hedge themselves against financial risks. Hedging financial risks is similar to buying insurance; hedging provides insurance against the adverse effect of variables over which businesses or countries have no control. Managing of risk increases stability at all levels, risk diversification improves the fair market pricing, thus there is general welfare.
  2. price discovery which refers to the knowledge of prices. The ability of derivatives markets to provide information about market-clearing prices is an essential part of an efficient economic system. Futures and option exchanges widely distribute equilibrium prices that reflect demand and supply conditions. Knowledge of these prices is fundamental for investors, consumers, and producers to make informed decisions.
  3. to provide transactional efficiency as derivatives lower the costs of transacting in financial markets. As a result, investments become more productive and lead to a higher rate of economic growth. Therefore, derivatives bring important social benefits and contribute positively to economic development. These benefits explain the massive growth in derivatives markets

Derivatives are traded in two kinds of markets namely:

  • Exchange Traded market, where derivatives are traded via an organized financial Markets/ intermediary. This category includes financial futures and options. These instruments have standard features like nominal size and maturity date. A derivatives exchange acts as an intermediary to all related transactions, and takes initial margin from both sides of the trade to act as a guarantee. The world's largest derivatives exchanges are the Korea Exchange, the Eurex and the CME Group.
  • Over The Counter is a decentralized market of securities not listed on an exchange where market participants trade over the telephone, facsimile or electronic network instead of a physical trading floor. Trading occurs through a network of middlemen, called dealers who carry inventories of securities to facilitate the buy and sell orders of investors. There is no central exchange or meeting place for this market. Examples of instruments traded in an OTC market include swaps, forward rate arrangements and options. These contracts are normally 'tailor made', that is designed to meet the specific requirements of the traders. However their costs are higher than exchange traded instruments. Also, the absence of a clearing house for OTC contract means that there is an element of default risk and it is largely unregulated with respect to disclosure of information between the parties since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds. Anyhow the OTC derivative market is the largest market for derivatives

Types of derivatives

Interest rate derivatives

The most commonly used interest rate derivative contracts by non-financial firms are swaps, with somewhat limited use of caps, floors, and collars. Interest rate swaps are contracts to exchange between floating-rate payments and fixed-rate payments. For example, if a firm wanted to hedge against the risk of an unexpected change in cash flow to be paid, it could enter into a contract to receive a series of floating-rate payments in return for making a series of fixed-rate payments, based on some estimated amount of the debt instrument. There is evidence that swaps of floating-rate payments for fixed-rate payments are more frequently used (Bodnar et al. 1998), indicating that firms may be more concerned with unexpected cash flow changes than with changes in the values of assets or liabilities, possibly a reflection of firms' debt structures.

Foreign currency derivatives

Foreign currency derivatives commonly involve forwards, futures, options, and swaps. Currency forwards are contracts that call for future delivery of a foreign currency at some predetermined exchange rate. Futures are similar to forwards, except for the fact that futures are traded on organized exchanges. Firms also use foreign currency swaps, which are contracts to exchange a series of interest payments in one currency for a series of payments in some other currency. These swap contracts may also involve a swap of interest rates, exchanging between floating-rate payments and fixed-rate payments. Firms use foreign currency derivatives as frequently as interest rate derivatives.

Commodity Price Derivatives

These derivatives are mostly futures, forwards, and swaps. Forwards and futures work in the same way to those involving interest rates or foreign currencies. Commodity swaps involve an exchange between floating-price and fixed-price payments where the floating price is based on some price as determined in a futures market and the fixed price is based on the spot price of a commodity, such as gold. These commodity derivatives, unlike those involving interest rates or foreign currencies, are limited mostly to firms that produce or use commodities, such as gold or oil.

Empirical analysis

Empirically, the use of derivatives by firms appears to be widespread. A large number of studies have documented the extent and nature of derivatives' use by non-financial firms. Some of these studies are based on survey data, such as the Wharton survey of U.S. non-financial firms (Bodnar, Hayt and Marston, 1998; Bodnar, Hayt and Marston, 1996; Bodnar et al., 1995), as well as other surveys of U.S. firms (e.g. Nance, Smith and Smithson, 1993). Surveys also have been conducted for selected countries outside the United States. For example, survey data are available for Canada (Downie, McMillan, and Nosal, 1996), New Zealand (Berkman, Bradbury, and Magan 1997), UK (Grant and Marshall, 1997), Germany (Bodnar and Gebhardt, 1999), Sweden (Alkeback and Hagelin, 1999),Belgium (DeCeuster et al., 2000), Switzerland (Loderer and Pichler, 2000), Hong Kong and Singapore (Sheedy, 2002) and the Netherlands (Bodnar, Jong, and Macrae, 2002). Overall, these studies document that the use of derivatives by non-financial firms tends to be the rule rather than the exception.

Corporate risk management is thought to be an imperative element of a firm's overall business strategy. The motives for the usage of derivatives have been widely studied by researchers, with the focus being on whether firms use derivatives for hedging purposes to maximize shareholder wealth or for speculation. Stulz (1996) draws upon extant theories of corporate risk management to argue "the primary goal of risk management is to eliminate the probability of costly lower-tail outcomes - those that would cause financial distress or make a company unable to perform its investment strategy". Bartram et al (2003), Mallin et al (2000), Henttsche and Kothari (1995) and Bodnar et al (1995) find strong evidence that the use of derivatives is in fact risk management rather than simply speculation. For example, firms that use Foreign exchange derivatives have higher proportions of foreign assets, sales, and income and firms that use interest rate derivatives have higher leverage, Bartram et al (2003).

In a study of the North American gold mining industry, Tufano (1996) presents evidence that is in line with the use of derivatives for hedging to lessen risk in response to risk-aversion by managers and owners. Finance theory indicates that hedging increases firm value by reducing expected taxes, expected costs of financial distress, under-investment costs associated with investment opportunities in the presence of financial constraints, and agency costs. Smith and Smithson (1993) study the use of derivatives by 159 large U.S. non-financial corporations based on their responses to a questionnaire. They find that firms using derivatives have more growth options, are larger, employ fewer hedging substitutes, have less coverage of fixed claims, and face more convex tax functions.

According to theoretical models of corporate risk management, derivatives use increases with leverage, size, the existence of tax losses, the proportion of shares held by directors, and the payout ratio. On the other hand, the use of derivatives decreases with interest coverage and liquidity (Smith and Stulz (1985), Froot and Scharfstein and Stein (1993)). Thus, Nguyen and Faff (2002) argue that leverage, size and liquidity are important factors associated with the decision to use derivatives.

The 1995 Wharton survey also found that derivative usage among large firms was greater than among smaller firms. This assertion was also reinforced in the 1998 survey, which found that derivative use is still not as widespread with half of the US population survey using financial derivatives of any kind. Bodnar et al (1995) also found that derivatives are used most often to reduce the volatility of firm's cash flows. Phillips (1995) found that as well as using derivatives for financial risk management, 67% of firms surveyed use them in conjunction with obtaining funding and 21% for investment purposes. Grant and Marshall (1997) carried out a study on derivatives usage in large UK companies and found that most large companies use derivatives and that derivatives are most often used to manage foreign exchange and interest rate risks. Mallin et al (2000) found this to be conclusive as well, with over 60% of companies reported using at least one derivative.

Although many firms and individuals use derivatives as part of an overall strategy to manage the various financial risks they face (e.g. interest rate risk, foreign currency risk, commodity price risk and equity price risk), misuse of these derivative instruments resulted in huge losses of several companies. Karpinsky (1998) and Singh (1999) discussed with examples, the various financial disasters relating to the use of derivative instruments. For instance, Sumitomo Corporation lost $3,500 million in 1996 because of Copper Futures; Metallgeselschaft lost $1,800 million from oil Futures in 1993; Kashima Oil lost $1,500 million from FX Derivatives in 1994; Orange County lost $1,700 million from Interest Rate Derivatives in 1994; Barings Bank lost $1,400 million from Stock index and Bond futures and Options in 1995; and Daiwa Bank lost $1,100 million from Bonds in 1996.

However the problems are not so much with the derivatives themselves but rather with the way that are used or misused. Some of these disasters have involved unauthorised trading (for example, the Barings bank), raising the possibility that a high number of companies may not have in place appropriate controls or monitoring procedures to regulate their derivative positions (Watson and Head, 1998). Thus, it is very important for companies to have well-defined risk management policies. It is also sensible for companies to outlaw the use of derivatives for speculative purposes.

In reality, there is nothing wrong with risk. As expressed by J Smith: "Risk is the lifeblood of business and the test of entrepreneurs and managers. What matters, is how risk is handled and the culture in which the company operates. The risk culture of a business is critical and must be established at the most senior level."

Requirements for the development of well-functioning and stable derivative markets

The trading of derivatives is governed by financial incentives and contractual covenants that ensure definite and unimpeded asset control, a reliable market and trading infrastructure, and a satisfactory and bankable legal and regulatory framework for bankruptcy, tax, and corporate governance issues as well as investor protection. The feasibility of derivative markets also requires the establishment of sound market practices, which include a good credit culture, information transparency, investor sophistication, relative price competitiveness across different asset classes in capital markets, an infrastructure of arrangers, clearing agents, exchanges and market makers as well as professional credit rating agencies to establish standards for risk measurement. These aspects are critical to the functioning of sustainable derivative markets, where systemic vulnerabilities are likely to be found in financial innovation that is governed by incentive structures that encourage greater risk taking in a benign economic environment but entail more adverse consequences when stress

From an investor base perspective, there is also a need for a balanced mix of speculative trading and natural hedging demand. Domestic retail demand may be speculative in nature and raises hidden vulnerabilities unless long-term institutional investors support genuine hedging demand. Sizeable retail trading of derivatives may also entail significant knock-on effects on real sectors; for example, a market downturn that inflicted widespread losses on households could affect consumer confidence and spending.

A good understanding of all these issues is incumbent on market participants as well as country officials charged with safeguarding financial stability and the sound operation of derivative markets. Given the increasing sophistication and complexity of financial products, the diversity of financial institutions, as well as the growing interdependence of financial markets, the adequate supervision of this important segment of capital markets will depend on the expedient and tractable resolution of challenges arising from the coherent implementation of risk-management practices, incentives for risk mutualization, and prudential standards that guarantee market stability in crisis situations. At the same time, the development of viable equity derivatives markets also necessitates financial sector initiatives, whose scope and intensity might be enhanced by coordinated policy efforts to improve market rules and trading standards with a view to minimizing risks and enhance financial stability.

Barriers to the development of derivatives market

While derivative contracts in mature markets are prepared under tried and tested norms of market practice and governed by a highly developed legal regime and close supervisory oversight (if exchange-traded), legal codes in many countries in Emerging Asia are silent on derivatives (Jobst, 2006). Statutory barriers and the absence of legal and accounting standards specific to derivatives seem to be lasting hindrances to further expansion of derivative markets. Only Hong Kong, Indonesia and Malaysia have local accounting standards that conform to IFRS. Some national laws either prohibit derivatives, fail to identify the regulatory jurisdiction over derivatives or make derivative contracts unenforceable by equating them to gambling, which is prohibited under Islamic law. Furthermore, a restrictive regulatory stance in many jurisdictions in Emerging Asia has engendered bans on short-selling (such as in India [15], Malaysia, the Philippines) or limited securities lending (in China, Indonesia and Thailand) for fear of systemic risk of settlement failure.

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