Role Of Financial Derivatives In Managing Risk In Financial Markets: Towards The Complex Exchange Of Risk, Speculation, And Fundamental Value

Role of Financial Derivatives in Managing Risk in Financial Markets: Towards the Complex Exchange of Risk, Speculation, and Fundamental Value

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Preface This research is based on the study of financial derivatives as understood to be the most violent objects of the financial industry. The first draft this research work was quite difficult to integrate as it appeared to be discrete units with independent focus of financial risk with role of derivatives on one side and fundamental value with financial fragility on the other. Continuous change and repetitive readings have made it possible to formulate the intended focus and a single line of argument for the four chapters. Seen initially as a very ambitious project, this is quite close to what in my opinion is happening in our financial times. August 2008

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Abstract Financial derivatives have been under criticism for various instances of financial instability. Taking that into account this research has been focused on analysing the role of derivatives in contemporary financial markets. This study originates from the research on perception of risk in financial economy and the innovations for controlling the future uncertainty by using the derivative tools. Role of derivatives and understanding of risk has been examined to bring forth the weakness and problematic nature of the concept of ‗fundamental value‘ of asset prices in financial markets. This notion of fundamental value is broadly discussed in the light of financial instability to provide the groundwork for observing the shifting perspectives on new and complex forms of derivative tools that exist today. The role of derivatives in financial economy has been under transition and this study uses different financial crises to examine the shift in perception of more and more complex forms of derivatives. It outlines that analysis of role of derivatives and their purpose of existence has to be observed in a board view of the economy as a whole. Through various arguments on the nature of derivatives trading, fundamental value, reconfiguration of risk in financial markets, the weakness of asset price bubble theories has been brought out to some extent. However, this study acknowledges the drastic consequences of derivatives trading and their use for speculative nature of investments in financial markets it emphasises that there is a need for a widening of the framework within which the role of derivatives could be analysed for a more comprehensive view of the financial management tools that have become indispensible to the global financial economy even with strong negative impacts on the economic stability of various economies.

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Acknowledgements I would like thank my advisor Dr. Andreas Antoniades for his invaluable comments and clear directions for building a sound base for research on the project. I would also like to thank my colleague Ms. Nathalie J. Louge for her invaluable time for discussions and strong encouragement for completing this thesis.

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Table of Contents

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Introduction

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1. Manifestation of Risk in Financial Economy

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1.1 Ideology of Risk

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1.2 Role of Risk in Financialization

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1.3 Future Value and Financial Risk Management

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2. Derivatives Theory, Use, and Effects

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2.1 Theory of Financial Derivatives

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2.1 Use of Financial Derivatives and Response of Financial Markets

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2.3 Effects of Financial Derivatives and their Role in Financial Risk Management 22

3 Fundamental Value of Assets in Financial Economy

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3.1 Investor Choices and the Concept of Value

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3.2 Volatility, Asset Price Bubbles, and the Concept of Value

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3.3 Financial Instability, Role of Derivatives, and the Concept of Value

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4. Transition in forms of Financial Instability and the Criticism of

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Financial Derivatives 4.1 Transition of Financial Derivatives with Financial Crises

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Conclusion

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References

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Introduction This research is a work on financial derivatives and their role in the economy. Financial derivatives have come under wide criticism for their destructive nature in the financial markets and the effects of same spilling into the real economy. It is important to understand the reasons for which derivatives have come into existence in the financial economy and their prevailing nature throughout the decades of developments in the global financial economy. A normal question as to why derivatives exist (Steinherr, 2002) in our global economy has been a strong debate in the contemporary literature on financial markets. Most theorists that argue against the role of derivatives and criticize their purpose of existence (Dodd, 2002) initiate a very crucial point of discussion. Financial derivatives have been innovated into ever more complex forms and hence become a very important part of our global financial system and have implications on the financial and overall economic stability of the world economies. Proponents of theories on asset price bubbles (Minsky, 1986) underline the speculative nature of investments is often associated as the direct consequence of the nature of trading and use of derivative tools. These asset price bubble theories base their explanations of the drastic effects that financial derivatives can produce, with the leverage (Harmes, 2001) available to the investors to speculate on different financial assets, has a fundamental problem in the nature that they build these explanations. The nature of these explanations has an orientation to the concept of ‗Fundamental Value‘ of financial assets (Itoh and Lapavitsas, 1999) that is problematic to define clearly and creates a weakness in the understanding that these theories offer to provide. So, this research attempts to breakdown the relationship between the risk of volatility that is captured by financial derivatives and the articulation of value in terms of financial assets that create the notion of fundamental value in financial markets. In order to analyze this relationship it is very important to denaturalize the basic conceptions of risk in the society, especially in the financial economy, and the inclusion of risk assessment to create risk management tools that further continue to expand in realization of new forms of risk. The analysis of risk society by Beck (1999) provides a substantial argument to observe the importance of inclusion of risk in modern society. Through this understanding of risk as a mode of creating opportunities towards new innovations, the financial economy is analyzed and developments within the global financial economy are highlighted to indicate the transitions that have lead to the increased importance given to risk management. The increased need for risk management is interlinked with the rise of widespread use of financial 6

derivatives. The break from dominance of the production economy and the transitions that led to the rise of the financial economy during the late 1960s and 1970s has been the most important point in the history of derivatives. As this transition was taking its shape the need to control highly increased volatility and fluctuations due to inflation problems, currency problems, debt defaults, and many other factors was rapidly increasing (Brenner, 2002). This literature review on the growth of financial industry (Helleiner, 2004) provide a sound basis for presenting financial derivatives as a socially constructed and need-driven innovation in the financial economy, with its roots well ingrained in the events and circumstances in the real economy that led to its deep penetration and firm control over the flows of financial capital and the volumes of investments in financial economy. Derivatives are presented through the theoretical explanations that outline the relationship of hedging and speculation (Working, 1978) in the financial markets. This helps to underline the original purpose of derivatives, i.e., ‗profit securing‘ for agents in the real economy, and the contradictions thus arising due to their use for evident speculative activity (Bernstein, 1998) in the financial markets. The focus of bringing forth this contradiction is to involve the debate of the existence of derivatives with the very important role of volatility in financial markets. Derivatives are driven by volatility and price change in financial markets is most important reason for their existence. But the combined effect of the two factors articulated have been used to indicate configuration and reconfiguration of risk that is performed using financial derivatives. The financial risks have been distributed to through the tools like derivatives but the spread of this concentrated risk creates further implications that lead to new innovations in financial risk management. This leads us to reach to a cycle of risk reconfiguration that automatically creates the need for further control the risk of volatility and price change and other factors that create risk exposures within financial markets. The argument that relates to the problems that this research engages with encompasses the role of derivatives in the financial economy as instruments that control volatility, yet simultaneously are driven by only volatility or price change for their existence. With this contradiction the argument takes a step further to integrate the understanding of fundamental value of financial assets traded in financial markets and the explanations of asset price bubble theories that are based on this understanding. It is a conscious effort within this integration of two different arguments, one indicating the role of derivatives and the other disregarding the notion of fundamental value in financial markets, to bring out the contradictions that are inherent to the financial markets and the overarching economic 7

framework in which they work. These contradictions can appear in the form of existence of derivatives even when they are strongly criticised to be the source of high volatility and instability in financial markets leading to financial fragility and threatening economic prosperity of different market economies, especially the emerging economies of the world. For the purpose of arguing against any significant reason for the concept of fundamental value, the same is put into perspective with a model bubble theory explanation (Stanford, 1999). In building this argument various factors like price-overshooting (Harmes, 2001) and positive-feedback (Sornette, 2003) have been analysed against the theoretical and practical framework of the bubble formation within financial markets and the real economy. This argument that is put against the unclear notion of fundamental value in such explanations does not undermine the occurrence of sudden asset price appreciation or cycles of self-fuelling and short-term bubbles appearing in financial markets and economic fundamentals, but it questions the basis of their reasoning that could be analysed within a timeframe to make use of fundamental value as a notion describing such circumstances. Underlying fundamentals for assets are argued as qualitative understanding of the market participants, as they have a tendency to move with consensus-building and converging expectations within these markets. This section of the research works on the relationship of „irrational investors‟ (Shriller, 2002) and formation of value for financial assets within the financial markets. There is also a close link that is provided between the role of derivatives in creating financial instability and the failure of mechanism of value creation to associate with the argument presented for the occurrence of financial crisis. This relationship highlights the insignificance of notions of fundamental value for financial assets and its problematic nature to be attributed to such relationships in order to understand the nature of financial instability. The incapacity of fundamental value to emphasize any concrete reasons for instability or the destructive nature of derivatives but interlinks the two by providing focus on financial instability and its changing nature with the developments in derivative markets over time. In order to capture this change East Asian Financial Crisis (Dodd, 2002) and the recently observed Subprime crisis (Pollin, 2008) has been put to comparison. This comparison provides the fundamental change that derivative markets have created in the nature of financial instability by spreading their effects into deeper corners of the society as they engulf newer forms of financial asset classes. In essence this thesis starts to articulate risk, especially in financial economy, to form a basis for the denaturalization of the existence of derivatives. With the deconstructed idea of 8

derivatives through its theoretical understanding and the contradictions that this theory creates with the practice of trading of derivatives in financial markets an important argument is drawn for an alternative view to the prevailing financial derivatives, their existence and innovation in the financial economy. The understanding of derivatives and the nature of rapid developments in financial economy since the 1970s underlines the problematic nature of fundamental value for financial assets. This problematic nature of the notion of fundamental value in financial markets is viewed in perspective of the asset price bubble theories to underline their weakness and also to reiterate the insignificance that diminishes the role of fundamental value for financial markets. The argument is further broadened to the different aspects of financial instability that are associated with the role of derivatives in the financial economy. The nature of explanations based on fundamental value do not fully embrace the framework in which the financial markets situate themselves and the imperatives that the developments in derivatives markets and financial industry in general have created for a new understanding for the existence of derivatives in the financial economy. The financial crisis in different times have been analyzed to portray the changing nature of derivatives and their penetration into the different fields of our society and the implications that this has for stability in financial markets and the global economy as a whole.

1 Manifestation of Risk in Financial Economy We start by the description of the ideology that drives risk (Beck, 1992) and its assessment in the financial economy. Using this ideological projection of risk in our society, an argument is presented on the changed nature of risk in the world economy since the 1970s, leading to an increased use of financial risk management tools. Financial risk is managed by tools that enable the creations of a price in the present for an asset or commodity which will be physically traded in the future. Originally the purpose of such tools was to secure the profits of producers and consumers and render smooth cycles of production and delivery, at a future date. The concept of „Future Value‟ in this argument becomes the reproduction of risk as a mode of creating new avenues for ‗profit generation‘ rather than ‗profit securing‘ against those identified risks (Steinherr, 2000). This argument is put against the theory of financial derivatives and futures trading to understand why derivatives are assumed to create value/expectation from an uncertain future. The argument engages with the criticism of the 9

role of derivatives as tools of risk management and underlines the pervasive risk vulnerabilities induced by such financial innovations.

1.1 Ideology of Risk Risk has always prevailed in every society and its organization, in the history of time. It is in the perception of risk within a particular society or a system that creates the notion of estimated risk. It is an idea that can be observed surfacing or amplifying with further developments in various fields in different societies around the world. Risk can manifest itself into many forms like the risk related to agricultural produce, weather unpredictability, production failure, unforeseen accidents, interest rate or exchange rate change, supply and demand imbalance, etc. All these factors, although they constitute very few modes in which risk can be understood within an economy, appear to have relevance in respect to how the different agencies within a particular economy perceive and calibrate the risk related to each of them. If we go back to ancient times, knowledge about anticipated events was a prerogative of an esoteric class of oracles and future predictors and the risk associated with the anticipated future was calculated in terms of the possibility of a certain event happening in favour of the agency involved. As noted by Bernstein (1998), the factor that separates the modern society from their past is their understanding of risk and efforts to master the tools that can control the unpredictability that is associated with risk. With a theoretical standpoint of institutionalism in the literature on political economy, the modern society is characterized by its nature of increased risk-taking that becomes the defining quality that drives this modern society. For example, ‗the Frontier‘ or the settlers were considered the more risktaking and practical headed section of the American society which shifted from east to west with an idea presented as the survival of fittest or the social Darwinism as articulated by Thorstein Veblen in Van Der Pijl‘s (2007) analysis of Pragmatism and Institutionalism. For the contemporary society risk has manifested in more complex forms as compared to the past. These complex forms result from the inventions and innovations in the social structures, the economic systems, and the political frameworks within which these societies have evolved. To understand the changes in the global economic system in the 1900s, especially the transition of different economies in the world from 1960s to 1970s, there is a conscious effort to bring out the incessantly growing knowledge, importance, and impacts of risk associated with economic systems and the financial systems. According to Ulreich 10

Beck‘s (1992) idea of the modern society as a risk society, the role of risk and its inclusion in the modern society serve as opportunities for generating benefits, which could be economic in case of the financial economy. Transformations in the modern society have been continuously producing new and different forms of risk. His ideological focus is on the tools that can minimize or channel the risk associated with the continuously developing modern society. Beck (1992) refers to this modern society as the ‗risk- distributing‘ society, acknowledged in the field of financial economy. This follows the recent developments in the global financial economy since the 1970s and the break from a working and profitable productive economy into the contemporary reoriented financial economy. This shift highlights the importance of risk through its new perception and its effect on the increased need for its management. This more detailed conceptualization of risk has created a new dimension through which the financial economy is observed. Many events can be accounted for the new perceptions of risk within the financial economy that have created a need for innovation in the tools that can manage this increased financial risk. However, the argument extends beyond the appearance of risk management. In Beck‘s (1992) ideology, this risk management calls for new and innovative forms of tools to control this risk and to minimize the effects of the risk by making certain of the knowledge of uncertainty. Yet, these new risk management tools are in themselves origins of new forms of risk that come to the knowledge of the modern society. Particularly, in the financial economy and its participants in case of this research, a threat is posed to the idea of risk management in the global economy as governed by developments in finance. In the last three decades of history of rapid financial developments, it can be observed that risk management tools in the financial economy lead to the creation of new risks that appear in various forms like market crashes, economic slowdown, weakening of the productive sectors due to high dependence on the financial growth for most economies, etc. Specifically, the growth of derivatives as tools of financial risk management have been continuously innovated into more complex forms to manage the ever increasing risk that reappears with new developments in efforts to control and minimize the risk associated with the financial economy. With financialization and the creation of the standard derivatives market within major economies of the world, the risk has been distributed. However, this development incites the production of new forms of risk has consequences for the wider community in the financial economy.

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Taking into account the developments in the world economy in the 1900s, there appears to be a clear distinction between the role of risk control before the Great Depression of 1929-30 and after the economically destabilizing events that followed the 1929 market crash, after World War II. After this crash, economies were strongly regulated for their economic revival and the efforts to control speculative movements of capital. Yet, the real changes within the financial economy appeared in the transitions in late 1960s and the 1970s. Risk was viewed with a new dimension in the rapidly growing world of finance (Bernstein, 1992). The increased manifestation of risk in an economy requires a further innovation of the tools that can control the risk and manage the unpredictability associated with that risk. Risk and management of risk triggers a vicious circle of self-repeating cycles where control of risk creates new forms risk by pushing the tools of its management to pose these new forms of risk. This cycle can be illustrated by agriculture as affected by the risk of weather changes or unpredictable turns that can harm the produce or create situations such as famines. Continuing on this example, the tools of monitoring the weather inevitably involve factors like failure of monitoring, precision of results, and information asymmetries. This creates further risks, and in turn, requiring further innovation to create systems to avoid the risk and cease the unpredictable nature that is understood in the new risks that have appeared. Focusing on the financial systems of the world, there have been many developments in the understanding of risks associated with it (Steinherr, 2000). The most innovative tools that have been created to control the financial risk are derivatives. Derivatives control the risk of various currency movements, interest rate changes, commodity price fluctuations, and several other factors that can affect the profits and revenue of investors like individuals, corporations, and governments. However, the risk management technique, as we understand it, further poses new risks that have to be managed with further innovation in the field. Thus, derivatives used in the financial markets have evolved for a long time and exist in very complex forms in the contemporary financial system as compared to the past. This complex nature has been drawn by the need of further control on financial risk due to surfacing of new its new forms with innovations in the financial system. To comprehend the cycle of risk related innovations in the financial system it is essential to examine the changes that have appeared in the global economy between the 1960s and the 1970s.

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1.2 Role of Risk in Financialization As Brenner (2002) cites in his analysis of the 1950s and 1960s, major economies in the world were inclined maintain the capital controls and was followed by the deregulation of most economies recuperating from the drastic effects of the WWII. This was a period of domestic economic growth, with minimum levels of international financial flows due to the capital controls maintained by economies like the US, western Europe, and Japan. During this period of domestic economic prosperity there was little pressure of international competition on corporations, which saw a continuous rise in their profitability (Brenner, 2002). Within these production economies, the risk was inherent to the process of production and changes in the supply and demand, specifically within domestic markets. The risk appeared to be controlled by the maintenance and creation of high demand within the economy as to stabilize again from the destabilizing effects of the World War II. Understood in this way, the risk is associated with a production economy within a framework of capital being used for generating goods and services within a strongly regulated capital flow environment. Therefore, it appears that the risk had lesser dependence on external factors and thus was controlled with appropriate policy decisions made by different political units within these economies. However, Brenner (2002) strongly argues against these most embraced explanations for decreasing rate of returns and incapability of states to regulate for a revival of increase in profitability starting in the 1960s. Due to factors like like falling domestic demand and the problems of ‗overproduction‘ and ‗overcapacity‘, this period comprised increased international competition (Brenner, 2002). These reasons lead to falling profitability for various corporations around the world, especially in economies like US, Germany, and Japan. This appeared to promote a disinterest in maintaining industrial capital within the productive economy and to maintain tight control over financial capital flows. These economies saw flight of productive capital to offshore deregulated financial centres like the „Euromarket‟ (Helleiner, 2004). This initiated a new age for financial capital. Deregulation was starting to appear in most major economies by the 1970s. Furthermore, the US economy was under a problematic condition because of the 1973 oil embargo (Helleiner, 2004) which inflated most commodity prices and lead to the depreciation of the US dollar against other major currencies in the world. This placed further pressure on the producers in the real economy and slowly under transition the financial economy attracted more capital flows. This marked the financialization of various economies around the world. 13

While the financial capital flows were becoming prominent during the mid 1970s, there was the rise of the global financial capital centres like London and New York, where capital flows were heavily deregulated. These new developments within the global economy were accompanied by new forms of risk manifesting themselves in various complex forms such as risk of inflation, currency pressures, and fluctuating profits in the production sector. As articulated by Helleiner (2004), most economies following the path of economic deregulation as financial capital flows became increasingly attractive due to reasons like the prominence of major economies (US and UK), which were following the path of deregulation and pursuing other economies to follow by using their strategic advantage over international trade and financial markets dependencies. Other factors include the attractive returns on financial capital investments and the deliberate efforts of most governments to refrain from controls over financial capital flows due to the risk of being left out from the financial developments (Helleiner, 2004). Cohen (1996) articulates that technological change as creating a movement towards financial capital flows and the attraction of American Financial system as also responsible for the deregulation of different economies. These factors indicate that financial markets were becoming increasingly important for economic growth and revenue generation through investments. With deregulated economies and financial markets, the capital movements accelerated their pace and resulted in an increased threat to economic instability due to the same factors that were responsible for stimulating growth in the economy. The risk associated with financial capital flows was clearly outlined by events like hyper-inflation in the in 1979-80 and the debt crisis that occurred in Latin America in the 1980s (Kindleberger, 1996). This risk appearing with the growth of financial capital flows and with numerous economies opening up to deregulate their financial markets incarnated a new appearance of risk in such economies. These risks had existed but had been controlled by government interventions or other agencies maintaining policies so that these financial risks did not appear as unpredictability in the future. From one perspective, the reasons why deregulation was being undertaken provides significant evidence that these economies were deliberately making policy decisions that lead to a „high-risk high-reward‟ environment within these economies and in the international markets. It is only the difference of how these risks have taken different forms in different economies. For instance the deregulation of the banking system lead to heavy lending by the private banks to developing economies with an associated risk of default. This is illustrated after the Latin American crisis when most private banks resorted to risk management 14

innovations like collaterals and portfolio diversifications (Das, 2005). This instance showed that as financial markets gained more strength, the significance of the risk inherent to the financial systems of the world increased. Higher risk based forms of profit generation required more sophisticated tools of risk management. During the late 1980s came the wave of widespread use of risk management tools called „Derivatives‟. It has been documented that the concept of derivatives as an innovation is not new to the global economic system as going back into history derivatives have been used as early as the 15th century (Bernstein, 1998). During the 1800s futures were used in the London Exchange to protect against the risk of price fluctuations. Derivatives are tools through which investors can protect their profit margins against the possibility of price change or occurrence of an unfavourable event, but it was only since the 1970s that derivatives gained a considerable significance in the financial economy. This was because the volume of the financial transactions had become increasingly large and thus created imperatives for the investors to widely use derivatives for securing profits against unavoidable price movements. Derivatives have been a result of increased risk in the financial economy. However the degree of derivatives‘ control on the risk within a financial economy is still questioned. Such a question requires a further understanding of the basic fundamentals on which financial derivatives are based.

1.3 Future Value and Financial Risk Management A financial derivative is a tool which derives its value from an underlying asset, where the asset can be anything that exists as a tradable entity (Bryan and Rafferty, 2007). This value is derived on the future expectation of the asset price movement to be experienced by the investors involved in the transaction of the particular asset. This introduces a risk associated with the asset price movement. This risk is calibrated in the form of price differentials and the observed value of a derivative derives itself from the expected future price of the asset. Risk as an opportunity is used in the form of future expectation that creates a value of the derivative representing the risk. The uncertainty of the future is quantified as a value that signifies the change in the price of an asset that is expected by the investor. This process uses derivatives to protect profitability against price movements. It is a very interesting phenomenon that uncertain futures are put into values that can be traded on the secondary markets with a convergence of interest on the expected value on a future date. This 15

transforms risk into opportunities of generating profits by trading derivatives with a view on future expectations. But risk will always remain a risk as it cannot be reduced to any other form. Derivatives, as risk management tools, can only spread or distribute the risk of price movements rather than reducing any risk that is associated with the future change in price of the underlying asset. Hence, derivatives cannot be said to control risk but spread risk so that producers or consumers have the opportunity to secure their profits against possible negative price movements. This poses the essential question that if derivatives secure profits of the producers and consumers than who bears the cost of a price change? To understand the role of financial derivatives as matching savers to investors (Stanford, 1999), it is essential to see identify the savers and investors that are involved in a financial transaction over a futures contract. On the other side of a derivative transaction is the ‗speculator‘. Speculators bet money on the price change in the opposite direction as the producer or the consumer they are transacting with (Steinherr, 2000). Therefore, speculators are looking to generate profit against a possible price movement. This is the ideological divide on the use of derivatives. With the definition of this financial innovation in the form of derivatives, they are profit securing tools that can be exercised by producers or consumers to secure profits. Yet, simultaneously they are being used by speculators to generate profit by using the same tools that are in place to secure profits for the agents from the real economy involved in the transaction. To elaborate on the origin, existence, and role of derivatives in the global economy the next section engages with the financial derivatives in relation to the financial markets theory. This helps to extend the argument that has been outlined in this section in relation to risk and risk society to the risk in financial economy and innovation of risk management tools. The problematic and contradictory nature of the existence of the financial risk management tools as briefly outlined in this section is presented to form the basis of the argument. The argument against financial risk management tools is necessary focus and be able to identify the relationship between risk of volatility in financial markets and the methodology that explains the control of this risk. In essence the motivation is to interrelate the concept of increased risk due to advancements financial economy and the role of this risk in the ways it affects the framework of financial systems and the economy as a whole.

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2 Derivatives Theory, Use, and Effects

2.1 Theory of Financial Derivatives The fundamental argument in theory of futures market presents financial derivatives as an institutional mechanism of risk management. Futures markets can be used by producers and consumers to sell or buy a certain actual physical commodity or other financial assets on a future date at a price that is decided in the present. This mitigates the risk of price change that could create unintended costs for the buyers and sellers. In order to manage the risk of price change, one can hold a futures contract in the futures market to either buy or sell a particular financial asset in the present to be physically sold or bought on a future date. The standard futures contract describes a certain quality and quantity of the commodity or the asset to be delivered on specified date and place, in the future. In financial literature, the process of risk aversion associated with price volatility in a transaction made in the actual physical commodity market is made by making a concomitant opposite transaction in the futures market, where this process is called ‗hedging‘ (Johnson, 1978). Hedging of risk in the futures market is a method by which buyers and sellers can exercise a „price lock-in‟ for ascertaining a preconceived cost or return. Futures trading is considered important for an asset or commodity which has a lag between the demand and actual supply of the physical commodity, for example, agricultural products and base metals etc. Based on the expectation of price fall the sellers hold „short‟ future positions while buyers, with an expected price rise, hold „long‟ future positions (Johnson, 1978). Although, hedging strategies wipe out the possibility of any profits that could be made if the prices were to go in the opposite direction than expected, it is still a mechanism for price stability in the international trade of physical commodities and financial assets. According to futures market theory, the derivatives traded on the futures market help create an efficient allocation of risk and, therefore, demonstrates sustainable price levels for different commodities and assets that are traded on any exchange (Working, 1978). This is based on the effect of a broad and transparent platform for demand and supply which restraints any disproportionate influence on price determination of a particular commodity. The underlying assumption for the explanation of existence of a price discovery mechanism is that the supply and demand factors related to the market are based on the actual physical 17

trade of the commodity or the underlying asset and there is a long-term (contract length) view for an appropriate price for buying or selling the financial asset on a future date. So, hedging strategy in a futures market is interpreted as an insurance against any loss bearing price movements related to this asset. Due to this interlinking of different financial asset prices, the reflection of any individual financial asset price is going to reflect the anchored value dependent on its relationship with all other financial assets, or the relative value. Brian and Rafferty in their analysis of the role of derivatives on the economy introduce two concepts of ‗Binding‘ and ‗Blending‘, where binding is of the future value of a financial asset into the present and blending is the swift convertibility of different financial asset forms, like swaps for interest rates to commodity futures (Bryan and Rafferty, 2006). This view is problematic in terms of analyzing a derivative market which is based on the assumption of „real‟ and „rational‟ valuations of future prices in the present. With this assumption the whole system of derivative pricing gets deteriorated, as in practice the pricing of financial assets in a futures market does not necessarily reflect the real „anchored‟ future value. If this assumption was to be correct, abnormal price fluctuations in stock and futures markets would cease to exist and derivatives would become the real reflection of demand and supply created by forces of production and consumption. When Brian and Rafferty comment on financial asset pricing ‗beyond speculation‘, there arises an inherent question as to why the speculation would exist if there was a real reflection of prices in any financial market. Speculation is an activity that is fundamentally motivated by the market oriented profit maximization strategy (Venkataramanan, 1965). Theoretically speculation supports a derivative market, like that of the commodity futures market, by ensuring that changes that appear in financial asset values due to price fluctuations, following the changes in demand and supply, are evened out by speculating in the opposite direction of price movements. So, if the price fluctuations lead to asset price appreciation, the speculator would sell and in case of asset price depreciation the speculator would buy, therefore, correcting the price value of financial assets through trading in futures markets. In theory this mechanism is useful as it would stabilize the underlying spot prices (Sunni, 2006) for commodities through trading in the derivatives on the commodity futures exchange.

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2.2 Use of Financial Derivatives and Response of Financial Markets Futures markets consist of the following two broad divisions of actors/agents - Hedgers and Speculators. Fundamentally, hedgers engage in risk aversion of price changes in the future by buying or selling a futures contract at the present price for a future delivery of the financial asset or commodity. Speculators, on the other hand, are actors which invest in the futures market to profit from the price change of a certain financial asset, or an underlying commodity as in the case of commodity futures, based on the expected price fluctuations. As the futures markets have witnessed that the majority of the trading in popular commodities or critical financial assets is undertaken by speculators (Minsky, 1986) as compared the volumes of futures contracts used by hedgers, there appears a contradiction to the original argument provided by the market oriented proponents of the futures market that hedgers and speculators balance out the price fluctuations that can occur in the financial assets or the underlying commodities. The contradiction arises because the more the speculative activity exists the more will be the expectations of a price change in the underlying commodity, as speculation dwells on price change or price volatility. So, derivative tools in the form of futures contracts, swaps, etc. are not just basic tools to hedge against the risk of asset price changes in the future, but an important mechanism through which a large number of investors engage in making profit without having any direct relation to the financial asset or underlying commodity that they are trading in. For example in the case of volatile base metals or fluctuating currencies, it is an added advantage that the price volatility is very high which in turn attracts high volumes of speculative activity. Volatility is a major factor in speculation as it provides the investors with short-term investments to make profits by trading against frequent price changes with leverage of low capital costs and transaction costs (Brown, Crawford, and Gibson, 2008). Derivatives have a form known as options (Bernstein, 1998). Highlighting their use in the financial markets can provide an elaborate understanding of the leverage that is provided to the investors, or speculators in the financial markets, with which they can take higher risks for profits while hedging against a maximum permissible limit for a possible loss into the uncertain future. As Bernstein clearly outlines in his analysis of derivatives and financial risk, options are the most convenient form of financial investments for volatile markets.

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Futures trading has a very important aspect that provides incentives for investors to go beyond the traditional methods of trading in futures markets, especially with volatile commodities and other regularly fluctuating financial assets. In futures trading the investors only need a margin, which is only a small percentage of the total cost of the actual physical commodity trade or an actual financial instrument transaction (Ciner, 2006). This provides an extreme leverage to the investors trading in a futures market because it generates avenues for traders who are not involved in the actual commodity transaction or with the underlying financial asset, but only identify the short-term outlook for profit motives vested in expected price change. This creates a potential condition for the use of speculative activity by even those who are hedging their risk exposures on these markets, in the attraction towards earning extra profits by engaging in investments for generating favorable price changes. Enron was an American energy corporation which went bankrupt in late 2001 due to their shift from the productive business of electricity and gas to large risky exposures in energy futures lead to massive losses. These losses were attempted to be hidden by fraudulent accounting principles, but revelation of such irregularities lead to the Enron debacle (Blackburn, 2002). So, there exists no clear line between the different actors involved in futures trading that can classify them as hedgers and speculators. Also, speculative capital generates large profits during the times of favorable investor expectations but such risk exposures often lead to massive losses to real corporations and real units of production and consumption within an economy. As stated by Jim Stanford (1999): “Financial Markets are a medium to match savers with investors and thereby fuelling the process of economic growth”. Financial industry works as the intermediary to manage the flow of capital between different economic agents to stimulate greater investment in the real economy for economic growth. The stock market, theoretically, is an institutional setup to generate new financial capital that can be used in the by industry in the real economy as new investments. Contradicting the theoretical basis and framework of financial markets, especially the futures markets, in reality these markets have become self-indulgent entities of exploding financial capital growth which is then reinvested in the same financial setup further aggravating the process of capital growth. The creation of new financial products as a conscious process of financial innovation is a method to contain the flow of capital with in the financial industry to create a vicious circle of reinvestment of capital raised from finance into new financial assets. In practice the relation between the industry in real economy and the investments made in it are arguably not generated by the 20

financial capital formation, as addressed by the theoretical framework of finance, but instead are entirely funded by the internal capital flows of the firms (Stanford, 1999). Therefore, it becomes evident that the financial investments made by corporations are limited to a shortterm outlook towards industry performance, which further advocates for the speculative nature of investments within the stock markets, and do not serve as the determinant of any major corporate investments within the industry or real economy. The futures markets or particularly derivatives run on speculation of asset prices. Volatility of currencies, bonds, stocks, futures market indices, etc. is crucial towards the process of increasing rate of returns on investments made into such financial assets. Fluctuations in asset prices are a natural consequence of the financial risk management tools that are traded in financial markets. The uncertainty of prices is reflected as volatility of the parameters governing the growth in real economy. As the financial markets and the real economy converge at factors like Interest Rates, Currency Exchange Rates, Securitization of Real Assets (like mortgage backed securities), Commodity Futures, etc. there is a clear interdependence of the two. These factors define the capacity to which the real economy can expand, borrow, and invest to maintain a methodical advance towards economic growth. In the same context Kurtzman suggest: “This tug of between the real economy and the speculative economy, while adding costs to the real, garner profits for the speculative. The two are in a way, in conflict with each other; not always, but usually. And they interact in ways we do not fully understand“(Kurtzman, 1993) Financial Markets have a tendency to overshoot in either direction, positive or negative, depending upon the inclination of the economic agents, whether government or investors, towards economic stability, growth credibility and other indicators of soundness of an economy. As Harmes puts in his argument that overshooting is a consequence of the false signals provided by the ill-representation of the „true‟ value of assets when markets do not operate efficiently causing poor economic synthesis and decisions. Overshooting of a currency, as in the case of the 1994 Mexican Crisis, is based on the high value of the currency relative to its true value in the international exchange market which creates a fundamental flaw in terms of overpriced currency. Due correction in this flaw creates a heavy devaluation of the currency leaving it with a negative overshoot which leads to a currency crisis situation (Harmes, 2001).

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2.3 Effects of Financial Derivatives and their Role in Financial Risk Management Derivatives have an impact on the financial economy as well as the real economy. The most important role of derivatives is to redistribute the risk associated with price changes borne by the productive sector of the economy. As put in their analysis on derivatives Brain and Rafferty articulate that system of derivatives perform the role of an anchor to the pricing mechanism of all other assets. In this view point on the role of derivatives there is an indication to the dependence of all assets to the existing complex network of derivatives that creates an elaborate mesh which introduces interdependence of events that results in price change of other assets (Bryan and Rafferty, 2007). In other words this network of derivatives that are used for a variety of different asset classes creates interlocks within their price determining mechanisms, as each event has an impact on different asset‘s values due to these inter connections created by this network. For instance interest rate change, whether be LIBOR or Federal Rates or Yen interest rate, all have an impact on the financial flows into other asset classes resulting in a new adjusted level of stability in different asset prices. Yen carry trade (Hartmann, 1998) is one of the most evident examples of this network of interlocked asset classes due to price impacts of Yen borrowing into other liquid assets like equity derivatives in other markets. With a change in the interest rate of borrowing Yen, the Japanese currency, there is a direct consequence on how corporations and institutions borrowing from the Japanese government react to this change by changing their positions in other invested markets. This appears in the form of a structural change in financial flows, which are highly liquid and create problems for various financial market products as this nature of liquidity of capital on most assets traded in these markets allow capital flight without regulation. To understand this further we have to introduce the role of derivatives as suggested by Brain and Rafferty to a more fundamental level of its association with the underlying assets and commodities. In relation to the theoretical argument of derivatives it is explicit that derivatives are risk management tools that mitigate the financial risk involved in market economies. In practice derivatives trading do not involve the principal or title of the underlying asset, commodity, or an event. Their purpose is to capture the change in this principal price of the underlying asset class to which they associate with. This price change could appear in the form of appreciation or depreciation of the trade value of assets on the stock market, precisely the futures market. This change could be a result of the imbalance of supply and demand, economic or political changes, financial capital flows in and out of any 22

market, etc. The importance of price change, in respect to derivatives, lies in the value that is created or lost in the event along with the factor that influenced the change. Each factor has its own impacts on the network, as is understood as a system of derivatives that interconnects and in turn influences other asset prices based on this change. The risk in financial markets is the price change that leads to negative or positive impacts for different agents involved in these markets depending on how the agents bearing the risk of price change are exposed to the instruments that engage with this risk, i.e., the positions that they hold in the futures markets following their expectations of price movements (Steinherr, 2000). The role of derivatives is to consume this risk by providing tools to these agents, like the financial institutions, governments, investors, producers and consumers from the production economy, etc. having exposures in financial markets to create positions through the use of popular financial derivatives like futures, options, swaps (Dodd, 2002) based on their expected and calculated projections of certain price movements in the uncertain future. So, derivatives are contracts that are able to configure and reconfigure risk in the financial markets. The configuration of risk that is defined by these contracts depends on the nature of the contract and its level of expected returns. High level returns operate on high risk, where change in conditions or future events create drastic changes in profits of the investors utilizing these tools, like Credit Derivatives (Das, 2005), which is the focus of criticism in the contemporary literature on recent innovations in financial derivatives. The capital employed in such derivative instruments is highly mobile due to its deregulated nature and creates implications for not only the investors but to the total economic stability of developing or emerging economies. The liquidity of assets in the secondary markets initiate new forms of risk as the derivatives are continuously emerging into more innovative and ever complex forms to mitigate and control the risk involved with this increased liquidity. The criticism of liquid assets, that create implications of instability in the financial markets, focuses on the rapid movements of capital. The capital flows have been a result of the widespread standardization of the derivative markets and close integration of most financial markets of the world. This integration of financial markets helps the financial risk to spread in a more diverse geographical form but simultaneously creates chains of interconnected asset classes that influence each other through a mesh of dependent factors. Derivatives used to control risk have come under criticism due to the volatility they introduce in the price movements of different asset classes depending on the liquidity of the underlying assets (Toporowski, 2000). If we analyse the risk that is associated with derivatives based on its 23

origination, which is the price change in asset commodity value, then we can draw an extension of this risk into the concept of fundamental value for the financial assets and commodities. Derivatives do not trade on stocks or bonds, events or changes in conditions, commodities, etc. Derivatives trade directly and only on uncertainty. That is the purpose of their existence and their only link to secondary markets, where uncertainty is to be minimized. Risk that derivatives work upon is not directly associated with a fundamental value of the underlying asset, rather the derivatives engage with the change in price or principal of the asset‘s trading value. So, the derivative trading becomes relevant only for volatility in the financial markets and is not in direct correlation with the fundamental value of the assets that are being traded in the derivatives market. Fundamental value becomes a superficial argument in terms of derivative trading, or in general for financial markets, because the notion of arriving at a fundamental concept of value for an asset is oriented from the processes of production and consumption in a productive economy and cannot be channelized into the financial economy in the same manner as is arrived at in a production economy (Knafo, 2007). The reason for this divide is that the productive economy has the capacity to bring in the value for inputs and create a margin of profit that leads to a fundamental value of any asset that is being produced. But in the financial economy, the analogy of inputs and profit margins does not find a place as investors are neither putting physical labor nor any other form of inputs, except for investing money in the form of financial capital on an expected future value that can maximize profits or secure their profits by hedging against unforeseen losses on the invested capital. So, even if there was a concept that can lead to a fundamental value for different assets in the financial markets, it can only reflect the convergence of market expectations over a desired price for any asset or a commodity over an elongated period of time. Contrary to the idea of fundamental asset price values in financial markets is the observed fact that it is possible for a market to hold asset values at a certain level during the stability of its index (the cumulative value of major stocks traded on that financial market) and the particular stock and its futures prices to be stable at a certain time period, and then completely change to a new stable level in a future time with respect to its past levels after a sudden rise or fall in the financial markets. In other words, if asset prices can be stable and acceptable at level A at a particular point of time T1 and be stable at level B at another point in time T2, not very different from T1, then what is the fundamental level at which the asset prices should have or 24

would be based on. This creates a contradiction for analyzing the existence of financial markets and the tools that are used within these markets to mitigate risk through the notion of a fundamental value for these financial assets. This contradiction will be brought to light in the next chapter which takes up fundamental value from its roots and deconstructs the understanding of fundamental value in financial markets.

3 Fundamental Value of Assets in Financial Economy

3.1 Investor Choices and the Concept of Value A neo-classical understanding for the value of an asset is based on consensus creating systems that lead to convergence of expectations around a fundamental value of a particular asset class (Kindleberger, 1996). This viewpoint is based on assumptions that markets are perfect and competition in the market is the mechanism through which pricing and valuation of different assets that are traded on the stock markets can be achieved. This provides a theoretical argument for the functioning of financial markets through a notion of market expectations converging to create asset values and the changes in asset prices which are determined by perfectly informed investors that take rational decisions based on the available information and taking into account the historical information. Future uncertainty in the markets is a result of changing trends in how investors react to change in information and the underlying fundamentals of the assets being traded. This uncertainty is transformed into a certain value in the future through historical averages and present information that create investor opinions to act for creating a consensus towards the present asset prices. In this explanation of future value and change in market expectations, information plays a significant role. All information is available to the investors, who in the neo-classical reasoning, are perfectly informed and able to arrive at certain prices through the use of the present information and comparing past trends with current change in market conditions. The use of information is assumed to be complete and decisions of investors based on rational choices that are made by the use of the change in information available.

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Many theories contradict this neo-classical view point by suggesting that often the new information available to the investors is weighted differently as to the historical averages that are available (Bernstein, 1998). The investors are affected by change in information. This leads to reactions based on partial information and overarching market opinions, hence rendering not completely rational choices made by the investors. A contradiction in the rationality of the investors and the investor opinions building in financial markets reflect the imperfections in these markets. According to these theories that criticize the neo-classical interpretation the rational choice investors are not fully rational beings, basing their choices on full awareness of the conditions in present and the past. Furthermore, these choices are derived from the opinions of investors mostly uninformed of mathematical models that attempt to explain the risk and management of risk for change in financial markets, reacting to present conditions with the most recent events and information available. This in turn forms the basis for change in asset price values (Steinherr, 2000). Market events are driven by antecedents and political, economic, and social circumstances that govern the nature of rational choices that investors exercise to make profits. Even when most assumptions call investors rational beings, these choices are not entirely rational due to use of incomplete information, tendency to follow market trends, and change in conditions creating different opinions among the myriad of investors. An institutionalist view point supports this idea of not fully rational investors, due to the reason that investors who are most informed are in the best position to make use of their resources to come to the best possible opinion for reacting to change in market conditions as compared to the choices made by partially informed investors (Shriller, 2005). Thus, the asset price change is a convergence of choices made by investors according to the information available to them and it constitutes a combined effect of the choices made by fully informed, partially informed, or uninformed investors. This convergence of market opinion does not reflect any substantial weight to form a basis for the values that financial assets are traded based on the choices made by various investors.

3.2 Volatility, Asset Price Bubbles, and the Concept of Value If we look closely into the working of the financial markets, there exist inconsistencies regarding the financial market institutional framework that might come to rescue the notion for a fundamental value for assets. The first rudimentary problem is the pricing of assets in 26

the financial markets. Due to the unavailability of any fixed mechanism or method to arrive at any stock‘s price or its‘ trading trends in the future, the value of these assets is a reflection of market expectations based on the variable use of the information that is at the disposal of various investors participating in these financial markets. The second problem is the trading of any asset‘s futures in the futures markets. Futures are based on the value that the underlying asset will create by a change in its price in the favourable direction, which could be either positive or negative, before the expiry of the contract for the particular derivative tool. Futures can be traded in the futures markets, or secondary markets, for generating profits or securing profits. The inconsistency appears when the motive for trading derivative products is transformed from its original purpose of securing profits to generating profits, with their use by so called ‗speculators‘ (Steinherr, 2000). As the profit generating motive can be executed with immense leverage, this creates an attraction for profit generation that uses these tools rather than profit securing which is mostly done by producers and consumers in the real productive economy. Thirdly is the notion of fundamental asset value in the financial markets which appears as the most contrasting inconsistency of all in the institutional framework of financial markets. This section of this research focuses on the concept of fundamental value to analyze certain theoretical explanations of financial market instability because these explanations create fundamental asset value as their vantage point for providing substantial reasoning for asset price bubbles or financial market crashes. Fundamental value for any asset whether it be tangible or intangible is based on the supply and demand concept that has been adopted from the production processes of the real economy. This concept controls the prices that are initially based on inputs like labour, raw material, invested capital, and expected revenue (Itoh and Lapavitsas, 1999). This only includes palpable assets such as the production of heavy machinery or the manufacturing of shoes that have a certain value attached to them. The capital invested has a purpose for return on what is being produced and bought by consumers for certain usage. The end product produced is introduced in the market with a value that reflects expected revenue that the seller of the product expects on its sale in the market. However, the role of supply and demand can change this expected value of the seller to a higher or a lower level depending on the supply of the product and the demand that has been created in the market. Thus, the market forces effectively play a crucial role in the price change for the product. Yet, there is a point of reference that can be associated with the process of production and an expected initial value or the fundamental value for the product can be marked. 27

For a financial asset like a stock or a bond or a future or an option, it is highly complicated to estimate its initial value. This makes it impractical to fix a point of reference that can associate a fundamental value for this asset. With the break in the late 1970s, where the global economy which was till then mostly dependent on production processes, there can be observed a transition into a global financial economy, where financialization of most economies in the world led to the growth of strong financial sectors, with much larger overall transactions of money and inflows of productive capital into the financing of liquid assets and generating profits from such investments. This led to the shift of ideology of a fundamental value for assets in the new formed global financial economy, which previously existed in the productive economy. In the viewpoint presented above the prevailing idea of fundamental value, has thus been adopted from the production economy, widely used by many theoretical viewpoints to explain the overshooting of prices or crashing of stock markets from their peak value (Itoh and Lapavitsas, 1999). To shed more light on the contradictions that arrive with the notion of fundamental value of assets in financial markets it is essential to discuss the creation of asset values in the world of finance. The value creation lies in the consensus making tendency of the converging market expectations for any financial market. Real assets in the productive economy are valued on the basis input costs and revenue generation that is expected over the invested capital in the process of production. For a financial asset the same mechanism cannot be assumed as financial assets are not real assets that need inputs and require capital for production. Most assets in financial markets are liquid in nature. For example interest rates, currency exchange rates, and mortgage securities are all mostly intangible liquid assets that do not have a clear and defined cost analysis that can identify a fundamental value for them. These assets are traded on the financial markets with market forces determining their trade value at any given point of time. Such assets have a trade value which can be highly variable and volatile due to their quality of acute liquidity. Fundamental value for such assets is a very relative concept mostly governed by the market expectation of the future levels of their price or value, and any relative timeframe can provide a new fundamental value to such asset prices. It is dependent on the theoretical viewpoint that analyzes this value, and within a timeframe, it can attribute certain price levels as fundamentals to the prices of the financial assets it engages with. This exposes the weakness of the asset price bubble theories in explaining the price bubbles as their reference point is not made explicit in most cases.

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Due to this undefined nature of the notion of fundamental value, the concept of fundamental value for different asset classes discussed in the literature on financial markets, especially futures markets, brings itself to a contradiction. When different theories on asset price bubbles discuss the formation of these economic or financial bubbles, their basis of explanation emerges from the idea of divergence of the financial asset prices from their fundamental value (Sornette, 2003). This can define the role of a bubble that emerges within an economy and its effects on the economic, political, social spheres of this economy, but the starting point of bubble theories have a problematic nature. This problem has been outlined as the notion of fundamental value based on which the analysis of speculation on future expectations against some fixed reference of stable prices is performed. As market participants follow their expectations of the certainty of price movements in either direction against the current price levels, the fundamental value of any financial asset price becomes dynamic with the changing expectations of the market. Alternatively, if we look at the concept of fundamental value from the aspect of underlying assets or underlying fundamentals, there is an important observation that can be marked in the way participants of financial markets react to change brought by events in these markets and pricing of financial assets following such events. To throw some light on the critical aspect of asset price bubble formation we consider an investor willing to speculate on the price movements of different financial assets. An investor forms future expectations based on the information that is available at present, the historical averages on the price of the particular asset, and the market expectation of the future price change for the asset (Bose, 1988). With this future expectation of certain change to the price of the particular asset the investor considers the fundamentals to change and take a new value in the future. In order to generate profits on the expected future price movements, the investor, or in this case a speculator, would base their decisions of the current underlying fundamentals and of the expected certainty of the fundamentals to change in the future on the market events and circumstances. By description in most theories in the financial markets literature the occurrence of these events and circumstances are considered to be mere convergence of the market expectations and anticipation for future change within these markets. Therefore, if the underlying fundamentals for most financial assets are also a convergence of the market expectation, then these underlying fundamentals do not form a sufficient and concrete basis for the conception of fundamental value of the asset prices that can be fixed as a point of

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reference for the analysis of a bubble formation and its burst in the financial markets or the economy as a whole. For example we see a derivative tool like a „futures contract‟ on a stock, being traded on the futures market, for the purpose of understanding the inadequacy of supplementing underlying fundamentals as any substantial reference for measuring price variations or in case of a bubble - price overshooting. Consider a scenario where a stock is being traded at a certain spot price of and the futures contract on the stock is bought at a particular premium value. A sudden shift in the market expectation for the stock can create significant investments in this stock, as it is the nature of investors to push the price higher and higher by investing in a rising price stock to gain profits by buying cheap and selling dear. In a short period of time stock rises to a new price level where it becomes stable again with the convergence of market participants expectations. In this way a dichotomy arises, questioning the level which this stock price can be considered as the fundamental value for the stock price. Both scenarios represent a stable state for the stock, within a given time frame, and the underlying fundamentals in each case have a variable context due to market expectations changing and converging at two different levels in two different times. Thus, for most financial assets a change in the underlying fundamentals is only theoretical concept (Harmes, 2001). In practice, the creation of the market consensus in the financial markets and convergence of its participant expectations form the basis for strong or weak underlying fundamentals. If there is a sudden price change then a reference to one supporting underlying fundamentals for a reference fundamental value of the asset price cannot be determined. The change in underlying fundamentals become only a reflection of the changing market consensus created by varied investor opinions over any given set of information that relates to the asset. Therefore, these opinions can result in the change of the asset price to a new value, which could be assumed to be fundamental within a certain time frame. Supporting this idea is the analysis of Harmes (2001) who criticizes the idea of fundamentals as something static that can be fixed as a point of reference for pricing of financial assets “...Determining the correct price for a stock, bond, or currency is difficult because it‟s part science and part art. It involves the science of researching what the fundamentals are and the art of determining what they actually mean. Determining what the fundamentals mean is difficult because it also involves guesses about what could affect those fundamentals in the future. Two investors looking at the 30

same set of economic fundamentals may come up with very different ideas about what the price of a particular asset should be” (Harmes, 2001)

Arguments are drawn to expose the problematic nature in understanding the fundamental value of financial assets and its relationship with derivative. To focus on and underline clearly the methodology of bubble formation suggested by the bubble theories and hence a common bubble theory explanation based on the Minsky‘s (1986) financial bubble analysis needs to described. A financial bubble is a condition of sharp appreciation of prices of the assets being traded in a financial market. This is called a bubble as in theory and practice the price appreciation does not account for any supplementing change in the underlying fundamentals of these assets. A boom in the financial economy is attributed to investor choices following the price change trends and the prime motive of buying low and selling high for maximizing the profit margins that can be achieved by trading in these assets. With a similar converging expectation of many investors within these financial markets can create a self-fuelling cycle of a circular chain events that create further appreciation of prices and thus there appears a sudden shift in the prices within a short period of time. When the price starts raising continuously more investors want to become part of the profit making community within these markets, the price pushes movements into a cyclical chain of causation. This helps to inflate the bubble that begins to appear with rapidly appreciating asset prices. This is accounted in Stanford‘s (2003) analysis of Minsky‘s bubble theory as the ‗herd behaviour‘. This describes most investors to follow the trend of investments that are being pursued and formulating choices triggered by events that are already inflating the market. If the markets were self-inflated then there would be a simple downfall in the value of asset prices from their peak value, where investor opinions would start to diverge from any further appreciation of asset prices, and the asset values would fall in the same cycle as they had appreciated before. However, investments made in the financial economy do not constitute a ‗zero sum‘ game because most asset valuations in the financial markets are closely linked to the decisions that various economic agents like governments, corporations, and individual investors make based on the apparent ‗paper wealth‘, as referred to by Jim Stanford, that they have gained with the asset price appreciation. ‗Paper wealth‘ is a concept based on economic agents in a real economy who are under an impression of an increased overall wealth due to gains that they have achieved in the 31

financial markets. These gains do not constitute any real wealth until the investments made in the financial assets and the gains achieved have been created into liquid positions by selling those assets in these financial markets. This phenomenon pushes for higher spending and lower saving thus fuelling growth in the real economy, like corporate profits or GDP growth in short-term. The increased growth leads to further appreciation of the financial assets and the cyclical upward movement of the asset prices is sustained in short-term. Thus, the idea of the bubble as underlined by Minsky‘s (1982) theory refers to the circular and selfpropagating build up of asset prices that create a wealth effect in the financial economy, as well as, within the real economy and creates a condition of highly inflated asset prices, named as a bubble in the financial markets and the real economy. The cyclical lending of the banks also supports the idea of increased growth, higher spending occurs due to increased bank lending and availability of liquidity in the market. Harmes (2001) introduces a very critical idea of price overshooting which corroborates the Stanford‘s (2003) wealth effect and Minsky‘s (1986) bubble theory analysis by providing an explanation known as a ‗positive feedback‘(Sornette, 2003) in financial literature. Returning to the original argument that most investors, contrary to the neo-classical view point, are not perfectly informed individuals making rational choices about their investments in the financial markets but rather follow the trends that are visible and rely on most recent information to base their decisions in creating future expectations in the financial markets. With any small movements in the asset prices, based on any false signals, causes the investors to make poor decisions over the asset price rise and, by the same nature of maximizing profit, margins investors push the asset prices further up by buying these tradable financial assets at increasing prices. This leads the markets to shoot in a positive or upward direction, bringing about the impression of ‗paper wealth‘ as discussed earlier. This creates the same cycles of increased spending, lower savings, increased bank lending resulting in more liquidity in the markets, and therefore, higher levels of debt. When the markets correct themselves the prices can overshoot in the negative direction creating strong imperatives for the economic agents as the ‗paper wealth‘ trickles down leaving behind greater amounts of debt than what can be repaid, much lower savings and low level of liquidity in the market as bank lending runs out due to a crisis of confidence also imposes the burden of increased debt for governments, corporations, and households. Similar logic can be applied to most financial assets, like currencies, stocks, bonds, and securities. The concept of price overshooting emphasizes the importance of the inconsistencies relating to financial markets that were 32

outlined before. Most importantly, fundamental value of assets upon which the bubble theory explanation rest the notion of price movements, cyclical self-fuelling price overshooting, or other such concepts like ‗paper wealth‘ will be considered in detail in respect with derivatives markets to see how the link between fundamental value and financial bubbles creates no direct correlation and thus a contradictory argument can be drawn against the foundations of these bubble theory analyses. With reference to the working of a derivative market as discussed in the last chapter on derivative theory and trading, we will go a step forward to examine the details of how derivatives can create a bubble as they are mostly criticized for creating volatility in financial markets and unstable financial asset prices by providing speculators with a leverage to take on the financial risk for high returns which could generate huge profits or result in equally high losses. Many theorists like Brian and Rafferty (2006) argue that price formation of from an asset‘s value takes place in the futures market based on which the spot market prices are formed. Thus, derivative markets according to this argument play a very important role in the price formation and hence price movements for financial assets. Derivative markets, by theory, serve to redistribute the risk through formal contracts where two different investors can have a different perspective on risk (Sunni, 2006). One is committed to divest the risk and the other is willing to buy that risk due to contrary future expectations of price movements. This relationship returns to the important link of derivatives trading to the creation of financial bubbles is the pricing of risk. If the investors are willing to take more risk, the prices of assets are pushed up in the futures market and the same is reflected in the spot price of these assets. When the futures are sold at a premium to the spot price, then the dominant market opinion reflects the future expectation of a possible price rise in the spot market for the same asset. Yet, the notion of a bubble within a financial market is in reference to certain fundamental price levels above which the price has been overshooting to appreciated levels. For derivatives the asset prices have no particular importance as they have been established to reallocate risk that is associated only with a price change for these assets. Derivatives encompass the risk of volatility in prices, and therefore, derivative trading is in essence the trading of risk or volatility. Therefore, this research argues that for a derivatives market, fundamental value is of no significance even in the instance of an existing mechanism to arrive at a fundamental value of any particular asset being traded on the financial markets.

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In the creation of a financial bubble, derivatives can be understood as drivers of the price movements that initiate the cyclical price appreciation. This can result in the inflation of prices on the spot and futures markets, as a consequence of such price changes. Speculators create market positions against the producers or consumers, who are willing to secure their profits by locking in a certain price in the present for a future transaction without real ownership of any asset or commodity in the present through the use of derivative tools like options. Speculators bear the risk that has been channelled to them that was initially borne by the producers and consumers. Speculators are assumed to base their investments on underlying fundamentals even if the price movements are against the expected returns in the short-term. This is due to the investments based on underlying fundamentals speculators profit in the long-run (Steinherr, 2000). These underlying fundamentals are the basis of the price formation for a fundamental value with the perception of the speculators. This implies that the underlying fundamentals create the fundamental value that comes under consideration for the purpose of profit securing or profit generation. However, when the concept of derivative trading is abstracted from principal asset prices and is only involved with the volatility of prices, the underlying fundamentals are variable with change. In this way, there is no specific fixed reference value that can be associated with the financial asset prices.

3.3 Financial Instability, Role of Derivatives, and the Concept of Value It is reiterated that the adoption of fundamental value from the production economy has entered into the financial economy as an abstract concept which cannot be made the basis for putting forward a theory with fixed references to values. This is because these values are variable in nature and are mostly formed in the mind of the investors that analyze any given set of information within a specific time frame. If presumed true, this contradiction brings into question the definition of ‗real economic fundamentals‘ (Toporowski, 1993). Underlying fundamentals could be understood as qualitative standards with which different investors perceive different expectations of price movement due to many viewpoints on the risk associated with any event within these markets. It is for this reason that investors buy risk while simultaneously there are others selling the same risk in the financial markets. If there was a certain view towards underlying fundamentals or a particular value associated as the fundamental value, then all investors would engage in a similar pattern of trading. This 34

would result in an impractical scenario where there would either be just buyers or just sellers of the derivative products, or in other words any risk would have only buyers or only sellers. This is not the purpose of the derivative markets and its innovative tools that allow the capture and control/redistribute the risk within financial markets. Hence, in the asset price bubble theories the concept of price overshooting or asset price amplification has a relative reference to the levels within a particular time frame. However, to generalize these theories to broader periods in the history it is useful to clearly define the concept of fundamental value that is assumed by the particular theory. The problem with bubble theories does not lie in the explanation of formation of financial or economic bubbles, but it is problematic due to the assumption of asset price appreciation at a certain point in time. If financial asset prices start appreciating and reach a certain level and then in the future the same prices still appreciate to a further higher level, where is the point of reference for the origination of the bubble? This is inherent to the explanations of the bubble theories where there is no relevance to the idea of origination of the bubble as it merely comes to a market convergence—possibly resulting in a consensus building towards the socially constructed reality of a bubble existing in the financial markets or the real economy. In order to generalize the various ideas that have been discussed for bringing out the problematic nature of the concept of fundamental value we consider the above explanation of the formation financial bubbles. The clear problem that the assumption of fundamental value brings with it is the idea that a financial bubble resulting out of continuously inflating financial market is always relative to an undefined fundamental level of the asset prices in that market and it is not possible for each investor to clearly and precisely constitute asset price valuations based on certain fixed fundamentals. This helps explain the ‗herd behaviour‘ by supporting the contradiction that fundamental value of asset prices remains undefined. Therefore, asset price appreciations will be perceived differently by different investors within different time frames. Thus, investors investing in certain assets at lower prices would view that as the profitable level with more appreciation. However, for another investor entering into the market with a late investment on the same asset would still be hopeful with the same optimism as the first investor, but within different time frames. This brings about three basic arguments against the fundamental value assumption: 1) markets are inherently volatile, 2) investors are not rational subjects with rationality of the 35

market being the rational whole of the individual subjects, 3) and price overshooting is a relative concept in the financial markets. First the financial markets that are subject to risk management tools like financial derivatives are inherently volatile because the role of derivatives is based on volatility in the markets without which the risk management tools becomes redundant. These markets have stability at different levels at different points of time, and therefore, the idea of fundamental value for the asset prices does not play a role. Hence, there is no fixed point of reference for asset price values. Secondly, for the fundamental value to be defined in the financial markets, the investor opinions have to constitute a rational choice convergence of the expectations for asset prices. As previously discussed, in the reality or practice of the financial markets, this cannot be the case due to investors being partially informed and being most affected by the most recent available information and events. The rational choice idea of subjective rationality is not justified in the case of financial markets as most investors are influenced by the overarching market trends and present circumstances. This is supported by Shriller‘s (2005) ‗herd behaviour‘ theory explaining investor psychology in financial markets The theory outlines that investor‘s rationality for future expectations is based on the overarching rationality created by events and circumstances within the market. Thirdly, price overshooting can be attributed to most convincing explanation of the asset price bubbles and its formation but the roosts of this concept lie in relative terms to asset prices within a given time frame. The fundamentals are dynamic in nature and to fix them to a certain value requires a reference time frame for which the theory can becomes a complete explanation to throw light on financial instability and market crashes due to financial and economic bubble bursts. Establishing that fundamental value is a problematic in nature to define and to realize its existence in financial markets we can focus on the factor that attributes financial derivatives a new dimension for future analysis. Volatility is inherent to financial markets and derivatives are as important as they are destructive in nature to these financial markets. So, there is a clear indication that financial instability has to be experienced in research within a framework of financial derivatives as they exist. Criticism of financial innovations through their impacts on bubble formations or price upsets is only limited to the abstracted level of understanding of financial management tools. There is a need to move beyond this abstraction and put efforts understand the existence of such destructive financial mechanism of risk control within the institutional framework of financial markets and the financial economies as a whole (Bryan and Rafferty, 2007). The next section would introduce the 36

notions of financial fragility in market economies with focus on certain cases of extreme financial instability. In order to delve into the role of derivatives and to understand that this role has become essential even when it creates weakness in the overall financial systems and to question the financial risk management tools for the purpose of their existence.

4 Transition in forms of Financial Instability and the Criticism of Financial Derivatives Financial Fragility is the concept of self-fueling financial asset bubbles which are selffulfilling and with intangible factors like investor mood swings these bubbles can bust creating dramatic consequences for financial markets, which spill over to the real economy which depend on these markets. “The boom and bust process can occur independently of the underlying economic fundamentals of the particular companies involved, yet ironically the cycle can have important effects that extend beyond the paper economy to the real investment of the real capital and the real production of goods and services. The financial ups and downs are entangled in a complex, dynamic web of relationships between asset prices (like stock and bond prices), interest rates, and the subjective confidence of company managers and consumers in the real economy. Economic growth itself becomes subject to the whims of the market.” (Stanford, 1999) In other words, with an initial asset price rise, weather based on real fundamentals or subjective expectations, the investors will buy assets to make profit by selling them in the future at a higher price. But these expectations of future profits are not always serviced by the financial markets. It would be too simplistic to discuss financial economy‘s rise and fall which affects asset prices with a concentration on just the financial institutional framework. In reality, it is a complex relationship between real economy where real goods are produced and real investment takes place and the financial market where these asset prices are subject to volatility and speculation. This complex relationship forms actor expectations in the financial markets, which in some explanations is based on economic fundamentals, but overvaluation of assets in a financial market are responsible to create the bubble effects within the real economy and its constituents, thus creating drastic consequences which reach

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further beyond the financial arena into the real economy, especially when actor expectations diverge and not correspond to the financial markets trends.

4.1 Transition of Financial Derivatives with Financial Crises For an analysis of the role of derivatives in the Asian crises, there are a lot of factors that created a combined effect for the crisis outbreak during the late 1990s. East Asian economies had huge inflows of foreign capital into their financial markets and real asset investments (Foreign Direct Investments) (Dodd, 2002). This foreign capital was under the risk of local currency dependence and a risk of depreciation pushed these financial flows to be hedged against possible local currency depreciation. For the purpose of hedging against this risk, various derivative tools like forwards and swaps were used. Using a forward contract the securities or other assets denominated in the local currency the foreign investors could be hedged against a possible depreciation in the financial asset value following the local currency depreciation. Similarly, there were many swap options that were used to restructure the transaction where the floating interest rates could be changed to fixed interest rates, currency denominations could be changed, and payments could be moved into different periods so as to avoid tax on income and earnings and likewise a lot of risk exposure could be removed off the balance sheets (Steinherr, 2000). Swaps were a major source of credit losses incurred during the Asian crises where most defaults appeared on the forward contract swaps. Apart from the regular hedging strategy that was used to minimize the risk exposure associated with being invested in the assets denominated in a foreign currency, there was a lot of speculation on the currency movements using the same derivative instruments. Derivatives, as discussed in the previous chapters, provide a greater leverage and lower transaction costs as there is no real exchange of any asset or commodities but only a price change that relates to the derivative investments. These were a major channel for investors, often referred to as speculators or currency attackers, to create positions against the stability of fixed exchange rates (Dodd, 2002). Use of derivatives created the lowering of the cost of investing against the fixed exchange rates, and therefore, only further encouraged such investor behaviour in the developing economies of East Asia during the late 1990s. If we relate this speculative nature of capital investment in the financial markets to the concept of a fundamental value, then there is a small room under which these speculative positions in financial markets against the fixed exchange rates could be justified based on some future 38

expectation of weak underlying fundamentals. Most of the speculation was due to readily available tools that had lower capital costs to create such positions in the financial markets for generating profits as market expectation was converging and most investors were following the trends to create a consensus of weakening of the local currencies within these East Asian economies. The influx of foreign capital within these economies was a constraint for the central banks to maintain fixed exchange rates and the speculators were betting against the capacity of the central monetary authority to maintain fixed peg for local currency for an indefinite time period. Carry trade was another offshoot of the availability of derivative tools that could be used in a fixed exchange rate system for generating profits on interest rate differentials (Hartmann, 1998). Borrowing at lower interest rates in the local currencies of the Asian economies and selling at a higher interest rate in the other currencies was becoming a common trend. The carry trade was profitable for the banks in the developing economies in Asia but resulted in the solvency of these financial instructions due to the exchange rates falling below the interest rate differential. All these factors and more were responsible for the Asian crisis and the prime role of derivatives in making the crisis into its exaggerated form is evident by the above explanation. It can be clearly observed that if there was anything fundamental to the financial bubble that was created in these economies it was the volatility that was captured by derivative instruments and redelivered into the market with further rise in this volatility. The subprime crisis that originated in the year 2007 in the US economy was a result of another form of securitized blunder that the financial economy can create within the financial and the real economy. Subprime loans are the high-interest driven mortgage lending due to their high default rate, as most subprime loans are not backed by collateral. With the extraordinary abstraction that can be created with the use of derivatives these subprime loans or mortgages could be transformed into tradable securities (Blackburn, 2008) that were being traded in secondary markets to generate debt finance. These securities ran into chains of securitization (Pollin, 2008) and were not a clear reflection of the risk exposure they had with the originating event. These derivative securities have been traded across different financial markets due to an increased standardization of the financial markets. So, the risk associated with the innovative forms of derivatives that are being traded today as compared their past forms are much more complex and have distributed high risk exposure to the other financial assets with the formation of linkages among various asset classes. Mortgage backed securities which are 39

used to raise capital in the secondary markets have surpassed the capital generated by US treasury bills since the year 2001 (Dodd, 2005). This clearly indicates the prominence that can be ascertained in the derivatives trading that exists today compared to its primitive forms. In contemporary period of financial markets, and derivative trading in particular, the risk has manifested itself in much deeper forms penetrating into the society and creating broader imperatives and serious social, political, and economic implications in case of financial instability. Like the very large scale securitization and trading of mortgages in the secondary markets creates systemic risks for the economy as a whole, as it interlocks real investments with highly liquid and high risk oriented financial assets. This has led to higher volatility and increased instability within the financial markets through the wide use of these newly formed streams of finance and their risk management through the use of derivatives. There is no fundamental reason to argue against the drastic role of derivatives but at the same time the imperatives of the current global economy make these tools indispensible as their materialization has been propagated through conscious efforts of innovating risk management (Bernstein, 1998). With each financial innovation unearthing a new form of risk, risk management in itself has become the source of future risk in market economies. Underlying fundamentals or fundamental value of asset prices cannot be argued as a concept based on any practical or theoretical existence because of the thick network of interlinked assets that has been created by the rapid developments in securitization of various new forms of asset classes. This highly integrated network of interlocked values for assets has led to the diminishing of clear definitions of underlying fundamentals or fundamental value for financial assets along with the increased source of risk and volatility in the financial markets. Theoretically derivatives still conform to the logic of controlling the increasing risk in the financial economy but in practice the role of derivatives can be viewed as a flourishing scheme to create newer forms of financial assets that can be traded and bet on for creating value in price change or volatility, thus inducing more instability in the financial markets. The comparison for two crises, one in the developing economies in East Asian in the late 1990s and the other in the US in 2007 that was considered the world‘s most strong economy, indicates a structural change that has been brought into the financial markets and the increasing span of available financial assets that can be traded on these markets. An observation made in the use of more sophisticated and complex networks created by the system of derivatives in the current global economy is that all financial innovations have had serious consequences for even the developed economies. The distinction of weakness based 40

on developed and emerging markets has been blurring due to the vast exposure of derivative products that can create instability in any economy whether be developed or developing by creating systemic risks for maintaining the streams of financial liquidity in times of instability, that can be caused with a trigger like the subprime defaults in the case of US financial markets in 2007. The risk has been effectively distributed for affecting the closely integrated and coupled financial economies of the world, and it is evident by the large losses incurred by investors in major financial markets of the world, whether be in developed or developing economies. To pass a judgement that this new formed face of derivative trading is a boon or boom for the global financial stability is still difficult, because to choose one stand seems to contract and undermine the horizon of understanding of the contemporary financial markets. But there is a definite increase in the overall risk that is posed by the ever complex derivative instruments. The innovation in derivative markets have brought a structural change to the global financial economy which now has much deeper direct linkages with the real economy, on the production and consumption and on the decision making processes, that create real investments and developments for economic growth for various economies in the world.

Conclusion The occurrence of derivatives and its widespread use in the financial economy has been considered as a natural existence that has no relation to the events and circumstances under which they have appeared and evolved in history. This line of argument undermines the role of real economy and the imperatives of transition and the developed role of the financial economy of the world. The analysis in this paper examines the period of late 1960s and 1970s as the period of transition from the dependence on real productive economy to the more influential growth in financial economy. Based on this analysis the paper argues that origin and growth of derivatives have its roots deep into the real economy and the circumstances which led to rapidly occurring periods of volatility and thus produced the need for creation and development of tools that could mitigate this risk and hedge the profits of producers and consumers that were badly affected by problems of inflation, currency exchange rate fluctuations, sudden commodity price hikes, and many similar factors. The basic outline that this argument creates is that financial derivates have been a conscious response of the agents in the real economy for the conditions that prevailed and have been dominant since the late 41

1970s in the financial economy and has its clear implications on the economic stability of various market economies. The risk that is captured by the use of derivatives is a socially constructed phenomenon, as according to the analysis of Beck (1999) risk has always prevailed but it is in the nature of modern society to identify and extract the uncertainty of future events and attempt to control the risk associated with this uncertainty. If this nature of modern society is analysed for the financial economy, its rapid growth and developments of new forms of financial flows produced conditions that created a need to innovate new forms of financial risk management appearing as financial derivatives. The continuous production of new derivative tools has manifested itself in the financial economy with a contradiction of their existence in theory and practice. With this deconstruction we can clearly observe that, in theory, derivatives have the role of managing risk by shifting the risk from more risk averse participants of financial markets to those who are willing to take on more risk with the desire of maximizing profits. This redistribution of risk has different interpretations in different theories but the distinction that has been widely discussed in the literature is the contradiction appearing due to the ideological separation of ‗profit-securing‘ and ‗profit-generating‘ using financial derivatives in futures markets. Speculation on financial asset prices is directly associated as one of the major use of derivative tools and the advantage to pursue such speculative activity with the leverage they provide for creating high risk exposure with small capital involvement. If we try to understand the basis of how derivatives work on the financial markets then this contradiction appears to fade as the theoretical reasoning of derivatives to stabilize the volatility inherent to financial markets and the capturing of risk and mitigating it for stability of prices weakens substantially. Derivatives work on price change, or volatility of financial asset prices. If the start point of derivatives and their only acknowledgement of existence is the volatility of prices then to argue against the volatility that derivatives induce in the market holds small significance. It also counters the theoretical distinction between the so called – ‗hedgers‘ and ‗speculators‘ as all participants in this market are willing to use the same tools that can create profits or secure a certain value, in the future. The most fundamental aspect to derivatives is their role of risk reconfiguration. Derivatives are made to capture risk and redistribute it among investors in the market but at the same time they spread the risk of price change to a much wider span affecting the profits of different market participants at the same time. This nature of derivatives creates a risk for the wider society 42

and has implications which move beyond the realm of financial economy into the real economy, the social conditions, and the political framework of the economies as a whole (Bryan and Rafferty, 2006). Bryan and Rafferty (2006) present a very important and unique outlook to the analysis of derivatives stating that system of derivatives create a mesh or network of interlinked asset prices by creating linkages among different asset classes. This has been possible because derivatives are not directly based the underlying asset or commodity but only on the price change of that asset. With much innovation during the last three decades in financial derivatives the new complex forms of derivatives are creating cross-linkages among different asset price change through instruments like swaps. Swaps provide the capacity to exchange the risk of one asset class with another without actual ownership of any assets with the investors. Such innovations have created strong imperatives for the financial economy as well as the real economy with interdependency of different asset price changes. Instability in one class of assets can produce a widespread affect on the stability of other assets and thus have become capable of creating much more complex manifestations of risk in the financial economy. The arguments on derivatives and the understanding of changes and developments in the financial economy raise doubts on the nature of value of assets within the financial economy. A value is important for an asset class until it is separated from external agents that do not significantly impact its prices. But in a complex network of derivatives this is highly unrealistic and observing the condition of volatility in the financial markets the notion of fundamental value losses its importance. But if we analyse the nature of explanations offered by asset price bubble theories (Minsky, 1986) then we arrive at a contradiction with the basis on which these explanations are presented. Using the model of bubble theory presented by Stanford (1999) this paper underlines the weakness of such theories as the lack in providing a timeframe to argue for the bubble formations based on fundamental value of assets. The problematic issue is the notion of sudden price appreciation that is based on the concept of underlying fundamentals and the unrealistic appreciations of financial asset prices which are not based on the underlying fundamentals that govern the price valuation for these assets. Fundamental value, if at all of any significance, is dynamic in nature as contrary to a static reference point based on underlying fundamental and this cannot be basis for the investors to make choices because it is formed out of a market opinion convergence. This market convergence has been argued to be a mix of opinions of different investors on the same set of information, events, and circumstances that form investor choices which cannot be 43

considered fully rational and, therefore, do not form any basis for the importance of underlying fundamentals in case of price appreciations. Harmes (2001) examines underlying fundamentals as problematic as the concept of fundamental value because to clearly determine the underlying fundamentals of any asset it is necessary to define the fundamentals for that particular asset. With different investor opinions underlying fundamentals become only a qualitative factor that have no significance but only reflections of overarching market opinions about various financial asset prices. So, the underlined problematic nature of fundamental value in some ways weakens the basis of asset price bubble theories, and thus the concepts of price-overshooting (Harmes, 2001) and positive feedback (Sornette, 2003) create a contradictory appearance in their own explanations while stating important factors of financial instability. Alternatively, financial instability as observed with the role of derivatives is effectively based on price change as derivatives have little relation to the principal asset prices and only work on the price change for these assets. Returning to the role of derivatives as stated earlier, the dichotomy is clear that derivatives are drivers of the volatility where at the same time their purpose is to control the volatility that is associated with the asset price change. Even in this argument the role of the asset price in themselves play little role and only price change for these assets is of most significance which in turn undermines the role of fundamental value in explaining financial instability. With the decreased significance of fundamental value as a concept and the role of derivatives as drivers of change in value the understanding of financial insatiability or financial fragility comes to various interpretations. It is inherent in the nature and working of financial markets to be volatile. Cases of financial instability have to be clearly identified and analysed with individuality because the role of derivatives is very important to explain certain implications on the instability, but simultaneously the form of derivatives and their nature of trading has been under transition since their use with rapid financial growth. The financial crises that have been observed in history have had different impacts and implication of the use of financial derivatives in the formation of the bubbles and their bust. The shift in the nature of trading of derivatives can be observed through this analysis and it indicates the growing control and firm grip that derivatives are making with their ever complex forms. As articulated by Bryan and Rafferty (2006) the role of derivatives have to be observed in the full framework of an economy with social, political, and definitely economic implications. The more influential role that complex derivative forms have played in each case of financial 44

instability since the East Asian financial crisis has unarguably created wider implications as more and more developments are observed in the derivative markets. But the alternative view to this argument calls for a different perspective in which financial crises should be analysed as the complex forms of derivatives have entered into the social and political setup of economies through the innovative financial derivatives like mortgage securities, etc. A comparative analysis of different crises can only offer a partial view of the role of derivatives in the contemporary financial economy. For a more comprehensive understanding of financial derivatives today they have to be analysed in a much broader sense and their role has to be separated from just labelling them as providers of volatility in financial markets. This view point indicates towards regulation and policy which can come to secure some aspects that severely damage the financial stability of an economy. There has to be a more clear and focused debate on the role of derivatives and a new understanding of their existence in the wider forms of society to gain knowledge on their continuous development and further complexity even in the face of their drastic effects.

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