The derivatives certainly make the markets more complete by rendering numerous benefits and advantages which cannot be realized by any other means or in absence of use of such derivatives. The discussion aims to highlight the various factors that support the use of derivatives such as extending the maximum flexibility which an investor can avail, any possible combination, and targeted rate of return that can be achieved by designing the best portfolio of securities. The cost of trading derivatives is far less in comparison to the creation of new securities. The derivate market makes the market more complete by creating a space to hedge risks., they also help in making the underlying market work more efficiently and proficiently. The report also highlights the use of derivative instruments such as Future, Forward, Swaps, and credit derivatives, various economic and financial benefits derived by introducing such benefits along with future implications of derivative trading.
Abstract
Derivatives are one of the most innovative ways to hedge company and individual risks. There has been considerable thought given on the issues, whether the introduction of derivatives has really helped in making the market more complete and meaningful or has created and developed a reason to fear. Definitely, a platform where people are able to trade with each other in new innovative ways is an appreciable activity, but at the same time, it cannot be denied that not all forms of derivatives are beneficial in nature. The current discussion aims to highlight the essence of derivatives in making the market more complete, with a comparison from both the perspectives of economic as well as finance.
Introduction
Derivatives, the financial instruments based or derived from the value of some other instrument are mainly circulated in the market for reducing and diversifying the potential risk. The derivative security market has shown a stupendous improvement in the last ten years (Sill K, 2008).
The diversified range of underlying assets is mainly the cause due to which a wide range of derivatives contracts are available to be traded and floated in the market. Derivatives are generally based on the various assets available such as equities, stocks, bonds, interest rates, exchange rates, CPI, etc. The most common derivatives used for hedging are futures, forwards, options and swaps. Though there exist many more, yet the ones mentioned above are the most frequently used for analyzing the market fluctuations and other changes.
The current survey statistics reveal that 64 percent of the US companies prefer using derivatives which in itself is a significant number to judge the worth and growing demand of derivatives (Balls A, 2008). Derivatives can be simple whereby contracts are created to buy and sell at a future period of time mainly referred to as forward and futures contract, on the other hand, contracts that have a clause to buy and sell at a future delivery date but with a constant predetermined price are called as ‘options’. Exotic derivatives comprise all possible availabilities in the field of derivatives on the whole.
Derivative market
The derivatives market is segregated into two cadres, the listed market and the unlisted market also referred to as the “over the counter” (OTC) market. Transactions under the listed market are controlled by authentic, recognized, regulated futures and options exchanges and no signs of failure have ever been reported in the listed derivatives market which makes it all the more secured, systematic and organized form of hedging, On the contrary, the main speculative areas have been, over the trade counter market which is almost five times the size of the listed market and is unregulated, privately negotiated and no collateral to support or minimize future risk. The clearing corporation is established to counterbalance any possible losses that occur. There has never been a failure in the listed derivatives market.
Commercial banks and investment banks are the basis for the establishment of the OTC derivative market (Dubofsky A D, Miller W T, 2003) which in turn looks after the development of the suitable market for the customers and laying off risks. The most fearful thing about the derivative is that the volume of the trading derivatives market is much larger than their fundamental and primary markets.
Future and Forward Market
In futures markets, contracts are traded on an exchange or index under the regulations laid by the government, on the contrary, forward contracts are negotiated directly over the telephone by two parties, hence there is no need to follow any kind of extensive rules or regulations or any sort of procedures (Hull C J, 2003). Margins are an important component of future markets.
Property derivatives, swaps
If we talk about the latest innovation and its proper usage then property derivatives just can’t be ignored, the real estate sector area continues to grow at a massive pace, where a remarkable interest is observed on the part of the real estate market participants in the establishment of commercial property derivatives.
Hedging of the private real estate risk has emerged as a new channel to gain exposure to the real estate genre without actually buying and selling properties and managing portfolios just by relying on the performance of a real estate return index. Again when such hedging techniques provide new investment and risk management by trading on property derivatives, there still prevails a fear whereby traders with a short-term focus lead to destabilization and more fluctuation possibility, regarded as a complex financial instrument rather than a preferred instrument of finance.
The derivative ‘swap’ allows the two traders to comply with the real estate strategies which cannot be actually accomplished in the private real estate market. From the financial perspective, index return swaps are able to create flexible portfolio management which completely eradicates the need for real delivery of the asset.
Derivatives help in overcoming the barriers of private real estate investment, especially eliminating or at least curbing high transaction costs, liquidity crunch, hence swap also proves to be an economical mode of gaining entry to international real estate markets.
In one of the interviews, the US Treasury Secretary, Henry Paulson, (2008), has expressed his views regarding the hedge which can be created against a diversified risk range. According to him, such deals certainly enhance the market efficiencies. He added that the major players of the industry dealing in the $62 trillion credit default swaps markets are working in collaboration with the Federal Reserve Bank of New York to centralize the proceedings of such customized trades.
Credit derivatives
The credit derivative market, in general, is faced with many issues and queries to be resolved in the future course of time, for instance in the case of the Delphi market, investors were brought up in a situation whereby they had to reassess their losses which were totaled to more than $2 billion, recent trading being 60 percent of their face value (Wharton, 2005). The credit derivative market was estimated to be worth almost $5 trillion by the end of the year 2004, which is almost double in the current times. Whether this rapid growth is a measure to curb risk or a way to channelize another uncomprehended risk into the market, is an issue hovering over the minds of the economists and financial analysts of the current market (Wharton, 2005).
The credit-derivatives market was introduced in the mid-1990s due to new mathematical derivations and insights. Credit derivatives are contracts that move up and down to monitor the movement of prices of the underlying corporate debt, such as bonds, stocks, etc. The credit market, on the whole, has simply expanded and proliferated in the last few years as many traders and investors were looking for yields that could surpass the returns realized by the traditional interest-paying investments (Wharton, 2005).
The total value of the entire world’s financial assets comprising of stocks, bonds, and bank deposits were pegged at t $167 trillion in the year 2007 while the derivative market on the whole trading as over a counter derivatives market was estimated to be $596 trillion in the year 2007 (Leibenluft, 2008). In a survey conducted by the International Swap and Derivative Association (ISDA), in regard to top 50 business school professors, his perceptions on derivatives revealed meaningful information in understanding whether the derivatives make the market complete or not. Respondents held a firm view regarding the importance of derivatives and continual growth in the future.
Economic benefits of the derivatives securities
The first and foremost benefit of derivative contracts is hedging against a variety of risks (Hull C J, 2003). The data extracted by the researcher reveals that the private-sector nonfinancial corporations have invested almost, 87 percent in the interest rate swaps, 64 percent in currency swaps, 78 percent in forwarding foreign exchange contracts, 40 percent in interest rate options and 31 percent in currency options (Sill K, 2007). When the derivatives are used to hedge risks, the derivative instruments pass on the risk from the hedgers to the parties who more are willingly ready to accept and bear the risk (Sill K, 2007). Thus the economic gain derived from the hedging exercise is to efficiently allocate and distribute risks among the different individuals and various groups existing in the economy (ISDA).
Another advantage gained is through speculation and carrying on the arbitrage activities. The use of a forward contract has an advantage over the use of other securities as it extends more leverage to the investor is purchasing the underlying asset in the cash market. Speculators provide economic gains as they are able to float greater liquidity in the market which helps other investors to trade on the best available derivative instruments. Arbitraging activity on the other hand helps in maintaining the asset market more liquid, reducing premiums and transaction costs
Another benefit that arises due to leverage helps inappropriate risk allocation, such leverage could be obtained with the help of forwarding contracts because no cash has to be invested at the time when the parties are engaging themselves to be a part of a new contract. Leverage can be gained in stock market transactions as well by buying stocks on margin. Current norms of the market, give leverage up to 50 percent of a stock to be borrowed provided it is a long-term loan (Sill K, 2007).
A complete market is supposed to be economically efficient and well organized. Efficiency could be attained by minimizing the barriers such as transaction costs, government interference, which can be ascertained with the help of incorporating such derivatives which move the financial market towards betterment and completeness (Sill K, 2007). The cost of trading derivatives is far less in comparison to the creation of new securities.
Financial benefits of derivative securities
Large firms can optimize their costing by trading with the derivative instruments, basing themselves on the principle of market completeness, as derivative securities provide investors with the low cost through the diversification of various portfolios. Inexpensive access to numerous classes of assets is an added advantage.
Derivatives, a ‘Threat’
In a model represented by Bowman D, Faust J (1997), a theoretical model has been developed whereby the soaring number of the different types of derivatives are held responsible for making the market more incomplete and reducing the level of social welfare. In the designed model, firstly an economy was considered which traded only in stocks, but that in itself was insufficient, so options were added to maintain equilibrium for promoting the concept of a complete market. The model demonstrated the economy which has two intrinsic states before the addition of options which totaled the figure to three intrinsic states whereby consumer 1 consumes and the Option is exercised, consumer 1 consumes but does not use Options, consumer 2 consumes and does not exercise the option.
In the second an economy was considered where two types of assets were uses, stocks and bonds. To prove whether the market was complete, all states were exploring where options, bonds and stocks were used together. But according to the model, it was found that three derivatives resulted in four states whereby consumer 1 consumes and the Option is exercised, consumer 1 consumes but does not use Options, consumer 2 consumes and does not exercise the option, consumer 2 consumes and exercises the option. The theory was proved as against the three types of financial instruments, four possible states were present. Thus the market was considered to be incomplete.
Derivatives make the market more complete
Derivatives make the market more complete, in the simplest sense that the derivative instruments provide identifiable payoffs which can be obtained by trading the securities which are available in the market (Kolb W R, Overdahi A J, 2007. They make the market more efficient as it offers scope for the borrowing and lending to occur at low rates than would otherwise be because derivatives help in the reduction of transaction costs.
Another instance could be quoted whereby in the year 2005, the National Council of Real Estate Investment Fiduciaries (NCREIF) had permitted Credit Suisse on the basis of its property return indices, an exclusive license to deal with the derivative contracts, in the form of return swaps. However, due to the failure of the arrangement which prevented the needed competition among the investment banks, the license was turned down. In March 2007, NCREIF adopted the model applied in the UK market in respect to the property derivatives on a non-exclusive basis. Currently, seven investment banks are working with NCREIF and almost $300 million are being traded in derivatives. On the other hand, few of the market representatives consider the new investment methods as complex financial instruments created by Wall Street investment bankers (Stulz R, 2004)
Derivatives in some terms are able to optimize the market potential but on the other hand, derivatives lead to less transparency and reliability of the accounting statements as well which opens more chances for speculation and misleading. For instance, Freddie Mac, the government-sponsored housing finance company, was found under the dire condition in the year 2003 because of concealing information, the company had used derivatives in order to hide billions of dollars of profits, hence adopted an unfair and misleading trade practice.
Another instance where the use of derivatives has been made in the form of swaps is the McDonald’s Franchisees. Two of the primary lenders to McDonald’s U.S. franchisees prefer swaps for fulfilling their financing requirements. One of the lenders had collected a large portfolio of fixed-rate loans to the franchisees and sold those loans to the investors on a floating rate return basis in the secondary market for the realization of the entire process, Interest rate swaps were used to convert the fixed interest rates into the floating-rate as per the need of the investors the other lender to MacDonald established a corporation that issued commercial paper to fund franchisee loans and used the same uses interest swap rate on a floating- or fixed-rate funding (Laura J P, 1994).
In a paper represented by Nguyen H, Faff R (2007), the link between the firm’s value and the derivative instruments is being found out in Australian firms. With the help of Connect 4 database, the data related to the listed Australian firms could be extracted. The figures obtained from Connect4 were later compared with the DataStream database to interpret findings on the market value of equity. The independent variables of the research measure whether a firm uses a specific financial derivative instrument or not and in the case where a firm makes use of derivatives, the extent of usage is also derived. A dummy variable was introduced which was marked 1 if the firm used a particular form of financial derivative and zero if it did not, FUFO used for futures and/or forwards, OP for options, SW for swaps. The extent of usage was calculated as the total notional value of derivative contracts ExtentFUFO, ExtentOP, and ExtentSW. The control variables used in the study for determining the extent of derivatives used are Firm size, Leverage, Liquidity and Profitability, Growth, Industrial Diversification, Geographical diversification, and Managerial Ownership. The major findings of the result were that the market evidently imposes a hedging discount on swap users. The extent of the hedging discount is extremely high. It is also found that the more expansively the firms make use of swap instruments; the lower is the ultimate value of the firm. Further, it is also proved that the choice of the type of derivative instrument also affects the firm value, swap contracts distort the value of the firm. As far as the futures and options were concerned, the risk was reduced through daily marking while the swap market did not represent any systematic approach for controlling risks. The final analysis which was deducted by the entire study was that discount was related more to the use of swaps and the use of options did not result in hampering the value of the Australian firms in general; hence the derivates do help in getting the market a little more towards completeness.
The derivate market makes the market more complete by creating a space to hedge risks., they also help in making the underlying market work more efficiently and proficiently. They are a great source in producing a deluge of market information especially related to the long-term interest fluctuations in varied countries which could be attained via financial instruments such as swaps, more preferable due to its liquidity in comparison to other instruments like bonds or stocks. To prove the efficiency of derivatives, an example can be explained whereby the short sales of stocks are often difficult to execute.
By adding a ‘put’ feature, investors are in an advantageous position to extract the adverse information regarding stock fluctuations. But derivatives from the economical point of view do create a high degree of speculation in the market, though not much evidence has yet been collected to verify such adverse and negative conditions. However, Conrad (1998) has mentioned that the exposure of options trading on a stock trading ultimately trims down the unpredictability and instability of the underlying stock.
Conclusion
After considering the market trends and patterns in the last few years it can be very concluded that the invention of derivative instruments and the establishment of the derivative market in many countries and regions across the world have been promoted in such a manner that derivatives are accepted as financial instruments which make the market or in other words are advancing towards making a market more complete by introducing the instruments and mechanism of risk-shifting development of the derivative market is essential in order to strengthen the financial market and the monetary policies. The rising significance of the derivative markets is attracting investor’s interest from all over the world. They play a positive role in the economy as they explored the enhanced price discovery and higher efficiency in hedging.
References
- Bowman, D. and J. Faust. (1997) “Options, Sunspots, and the Creation of Uncertainty.” Journal of Political Economy 105(5): 957-75.
- Rene Stulz, “Should We Fear Derivatives?” Journal of Economic Perspectives, 2004
- Laura J P, 1994, Derivative financial instruments: time for better disclosure, The CPA Journal , 1994
- Nguyen H, Faff R, Does the Type of Derivative Instrument used by Companies Impact Firm Value? SCHOOL OF ACCOUNTING, ECONOMICS AND FINANCE, School Working Paper – Accounting/Finance Series 2007 SWP.
- Kolb W R, Overdahi A J, Futures, Options and Swaps, 2007, Blackwell Publishing
- Dubofsky A D, Miller W T, 2003, Derivatives: Valuation and Risk management, Oxford University Press, New York
- Hull C J, 2003, Options, Futures and Other derivatives, Fifth Edition, Prentice Hall of India Ltd, New Delhi
- Sill K, 2007, The Economic Benefits and Risks Of Derivative Securities, Web.
- Balls A, Economics of derivatives, National Bureau of Economic Research, Web.
- Wharton, 2005, The Ballooning Credit Derivatives Market: Easing Risk or Making it worse, Web.
- Leibenluft, 2008, How can the derivatives market be worth more than the world’s total financial assets? Web.
- ISDA, INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION , A SURVEY OF FINANCE PROFESSORS’ VIEWS ON DERIVATIVES , Survey Conducted by The International Swaps and Derivatives Association, 2004, 19TH ANNUAL GENERAL MEETING CHICAGO.