Econ Essay

STUDENT MATRICULATION NUMBER: 080003025 NB. Do not put your name on either the cover sheet or on your essay. ______________________________________________________________________ University of St Andrews School of Economics & Finance Academic Year 2008-09

Essay Cover Sheet Level 2000 MODULE NUMBER: EC2008 MODULE NAME: TOPICS OF FINANCE LECTURER/TUTOR NAME: TUTORIAL TIME (if applicable): ESSAY TITLE: What are the specific roles and functions of derivatives in financial markets and in the real economy? Provide clear and detailed arguments explaining the role derivatives have played in the emergence and severity of the financial crisis of 2007-2008. In your essay, do not just provide a one-sided argument on the ‘evils’ of derivatives but also comment upon how the existence of derivatives markets enhances an economy’s ability to grow.

WORD COUNT: 1002 DATE: 10/12/09

What are the specific roles and functions of derivatives in financial markets and in the real economy?

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role derivatives have played in the emergence and severity of the financial crisis of 2007-2008.

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Comment upon how the existence of derivatives markets enhances an economy’s ability to grow.

Derivatives can be defined as financial products, such as futures contracts, options and mortgage backed securities. Most of derivatives value is based on the value of an underlying security, commodity, or other financial statement1. More simply, derivatives in finance have a similar basic principle as the field of Chemistry in which a derivative is defined as ‘a substance that can be derived from another substance.’2 Essentially, the purpose and initial function of Derivatives is to promote economic efficiency by hedging financial risk or speculation, as well as playing a role in helping minimize information asymmetry between depositors and administration. If this is the role they play, at first glance it is difficult to see how they are implicated in the 2007 – 2008 financial crisis. The idea and thinking behind the working of derivatives can be traced back to even Aristotelian times3 and is seen throughout history such as in the letter de faire, a form of future contract used in trading contracts in the 12th Century4. However it was not really until 1975 when the Chicago Board of Trade recognised that by turning future contacts into financial instruments, i.e. financial derivatives, risk could be hedged, that financial derivatives came into mainstream use. They seemed to be the instrument that would cure many problems, enabling people to formulate plans with greater confidence about the costs of their finance. Financial derivatives come in a variety of different formats; options, giving one the option to buy or sell something in the future at a fixed price, swaps, contracts allowing one to swap one cash flow for another and Future and forward contracts. They can also be divided into two categories, ‘Equity Derivatives’ and ‘Credit Derivatives’, the latter being the most common. Credit Derivatives give the user exposure to credit risk; the price is guided by the credit risk of the economic agents such as private investors or governments. Derivatives are used extensively in the financial markets and real economy because they do hold a substantial amount of benefits. They allow both firms and individuals to achieve payoffs which would not be achievable otherwise as well as enabling investors to trade information which would otherwise be unaffordable. This increases efficiency with in the financial markets. Without financial derivatives one would have to sell a stock which one does not own, often a challenging task, as such stock must be borrowed from he who does own 1 2 3 4

Morris, Virgi nia B: Stan dard & Poor’s Dictionary of Finan cial Terms (Lightbulb Press, Inc., 2007) pg. 55 Merriam Webster in c.: The Merr iam Web ster Dict io nary (Merriam Webster, 1997) Siems, T. F.: 10 Myths about Fina ncial Derivatives, (Cato Policy Analysis no. 283 – 199 7). Capasso, D. R.: Trad ing on the Seattle Merc, (New York, J. Wiley. - 1995)

them, inevitably making the process of the incorporation of adverse information in stock prices unnecessarily long-drawn-out. A derivative such as a put-option avoids this slow process. The financial market is rife with risk; essentially two attitudes can be taken towards dealing with this risk, risk aversion and risk seeking. It is in risk seeking that financial derivatives play a key role, moving from risk from the averse to the seeking. Derivatives are a sort of risk management instrument as stated earlie r; a derivatives value is dependant on price changes in underlying assets. Risk management of underlying assets such as bond, stocks and foreign exchange is executed via the means of hedging. To hedge is to make an offsetting position in a related security, for example in a derivative such as a futures contract, reducing risk for the underlying asset is transferred to another body. Successful risk management is key in promoting economic stability within the financial markets and is something that financial derivatives have a crucial role in. Derivatives transfer frisk from those who don’t want it to those who do (in hope of making a profit). By getting rid of this risk financial institutions are able to afford to invest more, promoting economic growth. Most derivatives are sold in private trade and thus are not as viciously regulated as trade in the public stock market is. It is perhaps here that we find their downfall, lack of regulation can result in misuse of derivatives this build up of misuse is argued to be have been one of the factors involved in the financial crisis 2007 – 2008. Securitisation, the process of combining assets to create financial instruments and regrouping them and putting them back on the market is one use which is subject to Criticism. Essentially Securitisation is the dispersing of debt, and with lack of regulation this can be done with the debtor unaware, and with little regulation the debt is consequently hard to chase. Derivatives are also dependant on the credibility of counterparties. Warren Buffet pointed out that "Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them.”5 The truce and initial concept of derivatives in itself does not necessarily have the potential to cause a financial crisis, however misuse and lack of regulation and knowledge can result in vast sums of money unaccounted for. Generally Derivatives are not documented on balance sheets as their payoffs don’t necessarily correlate with the notional amount and thus they would disrupt the sheet. However as a result of their off balance status, they can serve the function of wiping the balance sheet if necessary.

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Warren Buffet on Derivatives : http://www.fintools.com/docs/Warren%20Buffet%20on%20Derivatives.pdf

It is clear that derivatives enable economic growth, and that they have played a role in increasing the efficiency of financial markets, however misuse of derivatives and lack of regulation, and securitisation particularly in the field of mortgages has caused a reduction in their credibility. Perhaps just as key to their part in the financial crisis was actually lack of knowledge. John Eatwell of Cambridge University stated that “The problem is not a lack of transparency but their complexity and the lack of controls employed by buyers and sellers”6 and it is this that had an impact on the severity of the financial crisis 2007–2008.

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Eatwell, John: International capital markets: systems in transition (Oxford University Press US, 2002)