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Are derivatives the cause of a financial crisis?
Sugat B Bajracharya
Money and Banking
Research Paper
Abstract:
This paper looks into the pros and cons of financial derivatives while at the same time
glancing into past derivative-related crisis to explore the dangers of financial derivatives.
It also seeks to explore and investigate the role of credit default swaps in the recent credit
crisis. Overall, the paper seeks to analyze the current economic situation and past events
to see if financial derivatives are the cause of a financial crisis.
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Introduction
Following the volatility in the bond and stock market in the 1970s and
increasingly in the 1980s and 1990s, the financial markets became very risky as interest
rate swings widened. As a result of this, new financial instruments came into existence
that helped the managers assess their risks better. These instruments were in the form of
financial derivatives that have been very effective in reducing risk that many financial
institutions face. They are involved in hedging – that is engaging in a financial
transaction that reduces or eliminates risk altogether. “Hedging risk involves engaging in
a financial transaction that offsets a long position by taking an additional short position,
or offsets a short position by taking an additional long position.” (Mishkin, 2007, p. 333).
A financial institution is said to have taken a long position if they buy an asset. Similarly,
it is said to have taken the short position if it has sold an asset that it had agreed to deliver
to another party at some future date. (Mishkin, 2007, p. 333). Be it a forward contract,
financial futures contract or options and swaps, the key function that all of these
instruments provide is the “hedging” of the risks involved in the financial transactions.
It is the main purpose of the paper to analyze the pros and cons of financial
derivatives while at the same time glancing into past derivative-related crisis to explore
the dangers of financial derivatives. It also seeks to explore credit default swaps and its
role in the recent credit crisis. Overall, the paper seeks to analyze the current economic
situation and past events to see if financial derivatives are the cause of a financial crisis.
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Literature Review
Mishkin (2007) analyzes different forms of financial derivatives through a
detailed discussion of each in Chapter 13 of his book. In addition to these various forms
of financial derivatives like: forward contracts, financial futures, options and swaps, he
provides a brief history of how financial derivatives came into being and its explosive
nature that could cause a possible financial crisis. Moreover, the chapter concentrates on
examining how markets of each of these derivatives work.
The chapter provides a know-how of the financial derivatives which aids in my
research that deals with the analysis of pros and cons of financial derivatives. It proves
particularly helpful in examining various derivatives by providing detailed information
on them. More importantly, the end of chapter explores into financial derivatives as a
possible source of financial system collapse. This closely relates to the purpose of the
paper, in that, I intend to seek out the role of financial derivatives in the recent economic
collapse.
The Time Magazine article by Morrissey (2008) glances into the credit default
swaps market, introducing its existence and giving a brief overview of what it is and its
functions. The bulk of the article concentrates on how the market started, the key players
in this market and how it has the ability to create the next crisis after the sub-prime
lending fiasco. Moreover, it also looks into the ramifications of the meltdown or
slowdown in the credit default swap market. The article relates profoundly to my research
as it discusses the credit default swap market.
The final part of the article from the Arlington Institute by James Li (2007) deals
with the explosive nature of the financial derivatives and its volatile market that can
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impact the economy in never-before experienced manner. It provides illustrations of past
financial downfalls originating from derivative trading markets that could serve a vital
purpose in preparing for a potential financial crisis in the future. Moreover, the article
deals with the volatile nature of the derivatives in detail, outlining the reasons why the
market is so risky. It also looks into two of the past derivative-related events that rattled
the financial world. The article provides some illustrations for the paper in the form of
past events that further aids my research.
Thorbecke (1995) outlines the benefits and dangers of financial derivatives,
recommending policy responses to prolong the benefits and avoid the dangers posed by
the derivatives market. His analysis of the derivatives goes a long way in helping
generate a list of benefits and similarly point out dangers of the financial derivatives for
the purpose of my paper. His analysis includes historical references of the collapse of
Barings Bank and financial losses incurred by corporations like Procter and Gamble due
to the derivative trading.
Benefits of Financial Derivatives
“Derivatives are financial instruments that derive their values from underlying
assets such as stocks, bonds, or foreign currencies.” (Thorbecke, 1995, p. 2). Derivatives
can be traded both on organized exchanges as well as in an over-the-counter (OTC)
market. Typically, organized exchanges have rules that are enforced and the
clearinghouse guarantees the payment if the counterparty defaults. However, OTC
trading does not provide any guarantee as far as the financial transaction is concerned
(Thorbecke, 1995, p. 2).
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Financial derivatives perform many useful functions that benefit the economy as a
whole. They provide hedging of market risks, aid in increasing the value of firms;
improve efficiency of price signals, and increase profitability of the banking system.
Hedging market risk is one of the major benefits of financial derivatives. In
today’s market of fluctuating prices and interest rates, it is important for many to be
aware of such sudden changes. In order to protect individuals and businesses from these
fluctuations, derivatives are used to lock-in fixed prices or rates. This has the effect of
acting as an insurance against adverse situations in the future. Similarly, they also allow
for risks from a given cash flow to be unbundled, which increases the value of the asset in
question. For instance, Thorbecke provides an example of a 30- year bond that pays the
holder a fixed payment twice a year and the principal after 30 years. He points out that it
can be broken down into 60 coupons plus the principle that can all be sold separately.
This allows for individuals to purchase the duration and risk that they prefer. Hence,
unbundling of the asset into component parts increases the value of the cash flow
significantly. So, a firm can use the derivative instrument in distributing the risks and
increasing shareholder value. The pricing of assets are also influenced by the use of
derivatives and computer-assisted valuation strategies. In a market economy, asset prices
and interest rates are vital signaling factors that lead to the use and allocation of resources.
The market prices do not necessarily just reflect the fundamental factors. “The computer
assisted strategies allow investors to pinpoint interest rates and asset prices that are
inconsistent with fundamentals.” (Thorbecke, 1995, p. 5). Therefore, by purchasing the
underpriced assets and short-selling assets that are overpriced, the asset prices move
towards the fundamental values. (Thorbecke, 1995, p. 5). Last but not the least;
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derivatives can help in increasing the profitability of the banking system. Historically,
banks made profit on the spread between the interest rate they receive from assets and the
interest they pay on the liabilities. However, with the innovation of the financial
derivatives, banks now have the ability and potential to increase their profits significantly.
Although derivatives can have various beneficial functions, it is not prone from
misuses and dangers of failure. The next section deals with the dangers of financial
derivatives:
Dangers of Financial Derivatives
There are many major concerns that come up when dealing with financial
derivatives. First, derivatives allow financial institutions to hold an underlying asset that
is many times greater than the amount of money they have invested. An increase in
leverage enables them to take huge bets on currency and interest rate movements. These
can be very hazardous to the institution if they go wrong. This was the case for Barings
Bank collapse in 1995 where a young trader lost $1.5billion in Singapore derivatives
market. Hence, although the financial derivatives can be used to hedge against risks, they
can also be used to take excessive risks that have the capacity to bring down the whole
institution.
The second concern is that the financial derivatives are just too sophisticated for
average managers to interpret and understand its use. They frequently use complex
mathematics and sophisticated computer technology that managers are unable to
understand. (Thorbecke, 1995, p. 6). As a result of this, the managers are often making
decisions that they are not too sure about themselves. As long as the transactions are
profitable, they do not bother about how the derivatives operate and are managed. This
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can be seen as one of the possible causes of the Barings Bank collapse of 1995 as well.
Thorbecke (1995) points out that Barings manager sent $550 million to a Singapore
exchange when the 27-year old trader, Leeson requested it. Immediately following the
trade, the bank went under.
A third dangerous concern is that the whole economy is prone to the systemic
risks caused by derivative trading. Systemic risks are typically domino effects of a firm
or financial institution failing that affects other firms and even the whole economy.
Systemic crises can be disastrous as seen in the 1930s when banking panics occurred as
frequently as banks went under. As depositors turned up in large numbers to withdraw
their money, the banks could not find enough funds to cover them all. This led to the
gloomy financial days of the 1930s. Similar to the banking panic, financial derivatives
could also pose systemic risks if credit exposures are too concentrated among a few
dealers or parties. The situation could be further exacerbated if derivatives market are
illiquid and that they quickly transmit shocks from one market to another. The danger of
the credit exposure increases for the dealers because they mostly deal OTC derivatives
with each other. By avoiding the organized exchange, they miss out on the clearinghouse
guarantees which ensure that the counterparty is paid off if the other party defaults.
(Thorbecke, 1995, p. 8). Therefore, by trading outside of the organized exchange, the
probability of a firm defaulting and losing is high. This could cause other firms to follow
suit which can threaten the stability of the financial system. Moreover, the presence of
illiquid derivatives poses a danger that the hedging strategies could fail if assets held to
offset risks cannot be sold or can be sold only at deep discounts. This also has the effect
of making the firm involved in the transaction insolvent, spreading its losses to other
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firms and counterparts. So, the danger of close linkages between markets means that a
major financial firm in the world could affect other firms throughout the world.
Furthermore, with the advancement of many financial instruments and ever-
changing trend, the derivative market has become very volatile and can impact the
economy like never before. This is pointed out from the article by Li (2007) which
reveals an interesting piece of information about the volume of derivative trades. The
report predicts that more than 99% of total dollar volume of derivative trades is based on
the monetary sector of the economy rather than on the real sector (i.e. production of
assets, goods and services). The direct implication of this is that the risks involved with
derivatives and speculation is no longer tied down to the limits of real assets and
commodities. (Li, 2007). As a result of this, the derivatives market has become a
speculators’ paradise with traders and dealers capitalizing on volatility and instability of
the markets. Furthermore, there seems to be no real limit to the size of the financial
derivatives market as they are now free from constraints of production.
Hence, financial derivatives can be a risky venture in itself that can cause adverse
repercussions if not taken seriously. The recent financial credit crisis in the U.S. has
stemmed from the financial derivative that came into being in the 1990s – Credit Default
Swaps. The next section deals with the credit default swaps, its origin and role in the
recent credit crisis that has engulfed the whole economy.
Credit Default Swaps
“Credit default swaps are insurance-like contracts that promise to cover losses on
certain securities in the event of a default.” (Morrissey, 2008). It originated in the 1990s
with the first credit default swap done by JP Morgan bank. In the mid 90s, JP Morgan
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had tens of billions of dollars in loans to corporations and foreign governments which
required them to maintain huge amounts of capital and reserves in case the loans went
bad. JP Morgan essentially took 300 different loans that totaled to $9.7 billion which
included various big companies like Ford, Wal-Mart and IBM. By creating this financial
derivative, they were able to remove risks from their books and free up their reserves.
The CDS market has grown quite significantly since then and continues to grow at a
faster pace. According to the International Swaps and Derivatives Association, the CDS
market accounted for about $45 trillion in mid-2007 increasing from $6.4 trillion in 2004.
Corporate blowouts like Enron and WorldCom further encouraged the use of the credit
default swaps which contributed in this rapid increase in the market.
Initially, the CDS market primarily dealt with municipal bonds and corporate
debts in the 90s. The CDS market gained continuum as investors were very confident and
believed that the big corporations would not go bust in the flourishing economic times.
Gradually, the CDS market began expanding into structured finance that mostly consisted
of collateralized debt obligations (CDO). These mostly contained pools of mortgages.
This was generally due to the housing boom as mortgage-backed securities became the
hot new investment. Many of these mortgage-backed securities were backed up by credit
default swaps to protect against default. At the same time, it gained its dominance in the
secondary market as well. There were speculative investors, hedge funds and others
buying and selling CDS instruments. They were betting on whether the investments
would succeed or fail without being directly involved with the underlying investment.
However, the economy soured and the paradise for speculating investors during
the economic boom ended rather sadly. The sub-prime credit crunch started and slowly
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crept into other credit areas over the past year or so. It made the situation worse as there
were credit default swaps written on sub-prime mortgage securities. It was bad enough
that these sub-prime mortgage pools that the banks, investment banks, insurance
companies, hedge funds and others bought were overrated and resulted in falling in value
as foreclosures mounted. (Gilani, 2008). To further exacerbate this situation, the
speculators bought and sold trillions of dollars worth of insurance betting if these
securities pools would or wouldn’t default.
A lot of what is happening on the stock and credit markets is a direct result of
what is occurring in the CDS market. The series of events started with the bailout of Bear
Stearns which would be the first of many bailouts that were going to take place. Bear
Stearns had trillions of dollars of credit default swaps on its books that letting it fail
would have meant billions and billions of dollars worth of loss write offs for banks and
institutions insured by Bear. The counterparty risks that Bear’s trading partners faced
were so deep and widespread that letting it fail would have taken years of sorting out
losses and recovery. Similarly, the same thing happened to American International Group
(AIG). As of June 30, 2008, AIG had written $441 billion worth of swaps on corporate
bonds and mortgage-backed securities. (Gilani, 2008). They had to incur massive write-
downs as the values of the swaps fell which made the situation worse. As one default
happens, it starts a chain reaction that increases the risk of others going bust as well.
Moreover, many institutions are tethered to one another through deals consisting of
swaps which increase the risk of going bust. For instance, Lehman Brothers had more
than $700 billion worth of swaps, among which most of them were backed by AIG. As
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the mortgage-backed securities started going bad, AIG had to come up with billions of
dollars of credit default swaps. Eventually, AIG had to be bailed out by the Fed.
The main problem that the CDS market poses is the lack of regulation and
transparency. As a result of the heavy trading volume of the instruments and secrecy
surrounding these deals, occurrence of default makes it hard for the insured party to know
who is responsible for making up for the default and if they have enough funds to cover it.
Prakash Shimpi, managing principal at Towers Perrin, is all too familiar with the flaws
in the CDS instrument. He points out that there is no standard contract, capital
requirements or a way of valuing securities in these transactions. This has triggered
ramifications that have affected our economy through a credit crisis that has taken the
U.S. into a state of a recession.
Conclusion
Through the study of the benefits and dangers of financial derivatives and analysis
of the role of credit default swaps in the recent credit crisis as well as historical
derivative-related events, it is very obvious that they are very dangerous instruments that
can have adverse consequences if they go wrong. The disastrous and explosive nature of
the derivatives can be seen from the recent credit crisis brought on by the credit default
swaps that had nationwide ramifications on many financial institutions. Clearly, that is
why Warren Buffet calls the financial derivatives “financial weapons of mass
destruction”. (Mishkin, 2007, p. 355).
There have been calls for greater regulations and oversight on the activity of the
derivatives market as a result of many financial institutions going under. In the case of
the credit default swaps, it is likely that the federal government will start regulating them.
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However, no matter what regulations are set forth, the analysts are going to find a way to
go around the regulation to create new financial instruments. Moreover, the financial
derivatives are quite effective tools in hedging risks. But, when fallen into wrong hands
and irresponsive traders, they have unforeseen consequences that have the capacity of
taking the whole economy down.
Therefore, financial derivatives have the capacity of creating a financial crisis
which has been proven first-hand this year. The major part of the credit crisis was all
driven through the CDS market that resulted in many financial institutions failing and
needing bailouts like AIG, Bear Stearns and others. The Barings Bank collapse in the 90s
proved that derivatives trading in the wrong hands can prove disastrous. So, it is essential
to recognize the dangers that derivatives can pose as failure to do so can have global
adverse ramifications.
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References
Gilani, S. (2008). The Real Reason for the Global Financial Crisis…the study
no one is talking about. Retrieved June 2, 2009, from World Wide Web: htpp://
www.moneymorning.com/2008/09/18/credit-default-swaps/.
Li, J. (2007). Economic collapse overview. Retrieved May 20, 2009,
From World Wide Web: http://www.arlingtoninstitute.org/wbp/economic-
collapse/450#.
Mishkin, F.S. (2007). The Economics of Money, Banking and Financial Markets.
Pearson Education, Inc.
Morrissey, J. (2009). Credit default swaps: the next crisis? Retrieved May 20, 2009, from
World Wide Web: http://www.time.com/time/business/article/0,8599,1723152
,00.html.
Thorbecke. W. (1995). Financial Derivatives: Harnessing the benefits and containing the
dangers. George Mason University and The Jerome Levy Economics Institute of
Bard College.