Are Derivatives the cause of a Financial Crisis?

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.

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.

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 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).

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).