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Financial derivatives: applications and policy issues.

FINANCIAL DERIVATIVES are instruments whose value is derived from one or more underlying financial asset. The underlying instrument could be a financial security, a securities index, or some combination of securities, indexes, and commodities.

HISTORY AND EVOLUTION OF DERIVATIVES

The evolution of financial derivatives during the past two decades is related to the fundamental changes that have occurred in the financial markets. Innovations in financial theory and increased computerization, along with changes in the foreign exchange markets, the credit markets and the capital markets over this period, have contributed to the growth of financial derivatives.

The first exchange-traded financial derivatives emerged in response to the collapse of the Bretton Woods system of exchange rates established in 1944. Under this system, most governments agreed to fix the exchange rate of their currencies relative to the U.S. dollar, which was convertible into gold. In 1971, the U.S. Treasury abandoned the gold standard for the dollar, causing the breakdown of the fixed-exchange system, which was replaced by a floating-rate exchange system. The need to hedge against adverse exchange-rate movements provided an impetus for currency futures to emerge. Foreign currency futures were introduced in 1972 at the Chicago Mercantile Exchange ("Mere"). In 1973, the Chicago Board of Trade (CBOT) created the Chicago Board Options Exchange (CBOE) to facilitated the trade of options on selected stocks.

Futures contracts on interest-bearing government securities were introduced in mid-1970s. In October 1979, the Federal Reserve Board decided to abandon its earlier policy of setting interest rate targets and replaced it with money supply targets. The shift in Federal Reserve policy increased the interest-rate volatility of Treasury bonds (Remolona, 1993). The resulting increase in volatility invigorated the demand for derivatives to hedge against adverse interest-rate movements.

The advancements in options pricing research along with improvements in computer technology laid the groundwork for new portfolio management techniques. These portfolio management techniques required a futures proxy for equities that could be sold to hedge against a downswing in stock prices. The Merc and the CBOE responded to the needs of portfolio managers by introducing futures contracts on equity indexes in the early 1980s.

The increasing globalization of commerce is exposing firms to various financial risks, unrelated to their lines of business. Some of these risks are firm or situation specific with no ready-made exchange traded instruments to offset such risks. The management of these risks has created a new line of financial derivatives, the over-the-counter (OTC) derivatives. These derivatives are privately negotiated arrangements between parties that permit either one or all parties to obtain their desired financial flows. The OTC derivatives have grown faster than the exchange-traded contracts in the recent years (Remolona, 1993).

The Size of Derivatives Market

In a recently released study, the General Accounting Office (GAO) estimated the size of the financial derivatives market.(1) According to the GAO, the notional amount of derivatives outstanding grew from $7 trillion in 1989 to $17.6 trillion by year-end 1992. A more recent estimate by The Wall Street Journal places the notional amount of outstanding global derivative contracts at $35 trillion,(2) which exceeds the estimated total value of the world's stocks and bonds of $32 trillion. While the notional value of derivative contracts outstanding is mind-boggling, three clarifications are necessary to appreciate the size of the derivative market.

1. The "notional value" is the total principal of the underlying security around which the derivative transaction is structured and does not represent the actual amount exchanged in the transaction. For traditional securities, market value equals the price times the number of outstanding securities. However, the same valuation principle cannot be extended to derivatives, because the actual amount exchanged is uncertain at the initiation of the contracts. Thus, measuring the derivatives markets in notional amounts greatly overstates the actual amount exchanged during the life of the contract.

2. While generally the notional principal is only used by counterparts to determine the payments to be exchanged, there are exceptions to this rule. For example, the notional amount of some currency swaps is exchanged. Therefore, in assessing the size of the derivatives market, the relative mix of different derivative products also is important.

3. A significant fraction of the recent growth in the notional amount of over-the-counter (privately negotiated) derivative contracts can be attributed to market participants unwinding their contracts before maturity. In an exchange-traded contract, participants can "close" their positions before maturity by reversing their initial transaction. However, the privately negotiated contracts can only be "closed" before maturity by entering into another derivative contract that offsets the payoff stream of the initial contract. Therefore, the old contract remains in place and the new contract increases the measured size of the market.

In spite of these limitations in measuring the size of the derivatives market, the notional value of outstanding contracts does provide some indication of potential payments and the growth associated with derivatives. Another indicator of recent growth in derivative trading is the establishment of eighteen new derivative exchanges all over the world in the five-year period from 1986 to 1991 (Remolona, 1993).

DERIVATIVES INSTRUMENTS

Since their inception in the early 1970s, financial derivative instruments have mushroomed very quickly from simple financial futures to a wide variety of exotic and complicated securities. Table 1 presents the four basic types of derivative contracts, their underlying security, and their estimated proportion of the market. The table shows that derivative contracts using interest rate securities as the underlying security formed the bulk (62 percent) of all derivative contracts in 1992.

Futures contracts are exclusively traded at organized exchanges. The exchanges trade standard contracts on specific financial securities of specified amounts to be delivered at a designated time. Private parties enter into a contract with a central clearing house, which becomes the opposite party to the transaction. In this manner, the clearing house brings together parties seeking to take opposite positions. The risk of default by a party is low, because the clearing house is the opposite party and the clearing house uses daily mark-to-market settlement rules to reduce its risk exposure. Some of the most popular financial contracts include futures on Eurodollars, Treasury securities, certificates of deposit, municipal bond indexes, S&P 500 index, and New York Stock Exchange composite index.

Forward markets are simply an extension of spot or cash markets for deferred delivery of a commodity. Unlike the futures markets that offer standardized exchange-traded contracts with specific amount and delivery dates, forward markets consist of contracts that are custom-made and privately negotiated between parties. Table 1 shows that the financial forwards market comprises 42 percent of the global derivatives market. Foreign exchange contracts dominate the market for forward contracts.
Table 1
Composition of Global Financial Derivatives Market
(As of year end 1992)


 Percentage of Percent by
Derivative Type total financial Underlying Security underlying
 derivatives Security


 Interest rate 96.5 %
Futures 18 % Currency 1.0
 Equity 2.5


 Interest rate 27.0
Forwards 42 Currency 73.0
 Equity 0


 Interest rate 89.0
Options 13 Currency 3.5
 Equity 7.5


 Interest rate 82.0
Swaps 27 Currency 18.0
 Equity 0


 Interest rate 62.5
Total 100 Currency 36.0
 Equity 1.5


Source: General Accounting Office, Financial Derivatives: Actions Needed to
Protect the Financial System, GAO/GGD-94-133, May 1994.


Options differ from both futures and forward contracts in that a party to the options contract exercises its right only if the value of the underlying asset reaches a specific amount, called the strike price. Therefore, a payoff from purchasing an option occurs only when the price either drops or rises to the specific strike price, depending upon the type of the options contract. Options are traded both over-the-counter and at organized exchanges. Options can be written on individual equities, equity indexes, interest-rate instruments, and currency values. The initial pioneering research on options, including the seminal work by Black and Scholes (1973), was directed primarily at pricing equity options. However, over time the use of interest-rate derivatives has come to dominate the equity and currency options.

Swaps are privately negotiated contracts between two parties that stipulate the exchange of cash payments determined by the price of the underlying asset or the difference in the returns to different assets. Depending on the terms of the contract, the periodic payments could be a fixed amount or a variable (floating) amount based on either one or some combination of foreign exchange rates, interest rates, equity indexes, or commodity prices. By entering into a swap contract, parties are able to exchange their existing payment patterns for their desired payment streams. Swap agreements usually extend from one to ten years.

Other derivatives instruments. The four basic derivative instruments described above form the building blocks for creating a more complex array of custom-made and situation-specific derivative instruments. Some of these complex instruments are listed in Table 2. Abken (1993) and Kuprianov (1993) provide a more comprehensive discussion of different combinations of derivative instruments. Other financial products that have witnessed growth in the recent years include the "hybrids," which are instruments that have characteristics of more than one type of financial instrument. The list of complex derivatives is never-ending as innovative and creative financial strategists continue to develop new products tailormade for each application.

USES OF DERIVATIVES

Derivatives are used by businesses, individuals, and governments to accomplish a wide variety of objectives. Businesses use these instruments primarily to manage their risk exposure and lower their financing costs. Derivatives play a very important and necessary TABULAR DATA OMITTED role in the integration of world capital and production markets. Broadly speaking the major functions of derivatives are described in the following sections.

Risk Management

Risk management has been the traditional role of the futures markets and the driving force behind the development of financial futures contracts during the early 1970s. For example, traders use currency futures to protect (hedge) themselves against fluctuations in exchange rates that may be detrimental to their profit margins. A U.S. trader who needs foreign currency for a business transaction in six months could sell a futures foreign currency contract for the same amount maturing in six months. If after six months the U.S. dollar depreciated relative to the foreign currency, the trader would incur losses in the spot market, but those losses would exactly be offset by gains from the futures contract. On the other hand, if the dollar appreciated relative to the foreign currency, the trader would incur losses in the futures market that would exactly offset gains in the spot market. Thus, in a typical hedge, the gains/losses from derivative and spot markets tend to offset each other. Therefore, examining derivatives-related losses (gains) from hedging in isolation of the spot market gains (losses) is not meaningful. The media sometimes ignore this element of hedging transactions in highlighting derivatives-related losses.

While the discussion so far has been limited to hedging price risk, the prospects of any business are also influenced by quantity in addition to prices. Although quantity risk is difficult to hedge, some of the recent derivative products being developed, e.g., macro swaps, provide a means to hedge quantity risk (Marshall et al. 1992). A macro swap is a fixed-for-floating swap of payments in which the floating payment is tied to some macroeconomic index (such as employment, GDP, or consumer confidence). A prudent use of derivative products can provide a mechanism to reduce various business risks at low transaction costs.

Lowering Financing Cost

The creative use of derivative products can enhance a firm's ability to reduce its cost of debt. Businesses can generally use derivatives to reduce their financing costs by the following mechanisms:

1. A business may be able to obtain better financing terms from lenders by reducing the risk of its venture by engaging in hedging activities.

2. Firms can capitalize on differences in interest rates across borders and maturities. A firm could issue debt in a country with lower interest rates and use currency swaps to protect itself against foreign exchange risk.

3. Firms can benefit from "quality spread," which arises due to differences in interest-rate spreads between fixed-and adjustable-rate credit markets. Typically, the quality spread between firms with higher credit ratings and smaller firms with lower credit ratings is larger in the fixed-rate market than the adjustable-rate market. Firms can take advantage of this phenomenon by engaging in swaps and effectively reduce their interest costs.

It is also possible to reduce financing costs by using interest-rate swaps and swaptions to transform callable, putable, floating, and nonconventional debt to other forms of debt (Goodman, 1993). In addition, businesses could use derivatives to take advantage of low interest rates to lock in the financing costs of a future debt issue.

Asset Management

Derivative instruments play an important role in asset management because of the low transactions costs associated with acquiring derivative instruments relative to the spot market instruments. For example, the payoff stream from holding all equities in the S&P 500 list can be replicated by a futures contract on S&P 500 index at a fraction of the cost of acquiring all 500 equities. Other derivative instruments can also be used in a similar fashion to reduce transactions costs.

Completing the Market for Investors

Derivatives provide investment opportunities not available at organized exchanges. Derivatives offer investors with a means to venture into unfamiliar equity markets around the globe at lower cost and risk than the traditional means. OTC derivatives tailored to meet the needs of specific business situations also extend the investment and capital formation opportunities beyond those offered in equity markets.

Tax or Regulatory Advantage

Derivatives offer firms tax planning opportunities by taking advantage of asymmetries in the tax and the regulatory requirements across different countries, markets or securities.(3) Derivatives can be used to issue debt in tax-favored jurisdictions or through a tax-favored instrument to replicate the payment stream of a high taxed jurisdiction or security. Derivatives may also be used by some regulated industries to reduce the impact of certain regulatory restrictions and limitations.

Speculation

Derivatives are also used to speculate on the price of an interest-bearing security, on the value of equity indexes, and on foreign exchange prices. Speculators are motivated by the gains from their speculative positions and by the risk premium they charge for providing hedging services.

In general, derivatives provide a useful function by reducing price uncertainty, which has a positive impact on the overall economy because the production levels are higher under certain prices relative to uncertain market prices. Derivatives facilitate global commerce by providing firms with an ability to reduce their foreign exchange risk, reduce their cost of obtaining funds, and reduce the risk and transactions costs of investing in foreign equity markets.

Several risks inherent in the use of derivative instruments are beyond the scope of this paper. These issues are addressed in a recent report on derivatives prepared by the Group of Thirty, which is an international policy organization whose members include representatives of central banks, securities firms and dealers, and academia.(4) The report offers a good framework for dealers and end-users to design an effective and prudent risk management system. It encourages senior management to develop clearly defined derivatives policy and establish quantitative controls to monitor their derivative position and risk exposure. The report recommends using mark-to-market valuation principles and stress simulations to quantify the potential risk exposure.

POLICY ISSUES

Derivatives activity is regulated largely by type of instrument and by the entities involved in the transaction. Exchange-traded derivatives are regulated by the Commodity Futures Trading Commission (CFTC), and the Securities and Exchange Commission (SEC). The CFTC has the mandate to regulate contracts derivative to commodities, including commodity futures, commodity options, and options on commodity futures. The SEC has regulatory authority over securities and options on securities. The regulatory agencies oversee the exchange rules for margin and capital requirements, trading limits, and consumer protection. OTC derivatives on the other hand, are not regulated by any agency except to the extent a user may be regulated by its primary regulator.

The primary regulator could be an agency with oversight responsibilities for an industry. The banking industry is supervised by the Federal Reserve Board (FRB), the Office of the Comptroller of Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), and the Office of Thrift Supervision (OTS). Similarly, state insurance commissioners oversee the activities of the insurance industry. The primary regulators of end-users use tools like capital standards and disclosure requirements to safeguard the public interest from use of derivatives by the regulated sector.

In 1992, the Congress passed the Futures Trading Practices Act. This law provided CFTC the authority to exempt from its oversight certain contracts, including some hybrid and swap agreements. Prior to the passage of this law, a significant uncertainty existed over the jurisdiction of CFTC and SEC for hybrid instruments that have both a "commodity-like" and a "security-like" feature.

Derivatives Use by Insured Institutions

The lingering memory of the savings and loan crisis has made the Congress very sensitive to derivatives trading by the U.S. banks. Therefore, one of the major concerns of policymakers is the potential for speculative activities that involve federally insured deposits. Policymakers are worried that the failure of a major federally insured derivative market participant might threaten the financial insurance system, and risks taken by banks may ultimately be borne by the government and taxpayers. The House Banking Committee held hearings on the issue and the minority staff of the committee has issued a lengthy report on derivatives.

In 1994, the chairman of the House Committee on Banking, Finance and Urban Affairs, Rep. Henry Gonzalez (D-Texas) introduced legislation that would strengthen the regulatory powers of federal deposit insurance agencies and require banks to disclose their derivative activities in full. The legislation would also require the Treasury and the GAO to conduct studies to explore various derivatives-related issues, including the international risk exposure, linkages arising from the use of derivatives, and the feasibility of imposing a tax on derivative transactions. The ranking minority member of the committee, Rep. James Leach (R-Iowa) also introduced a bill that deals with derivatives markets. The Leach proposal would establish a Federal Derivatives Commission that would bring together all federal financial regulators. The Commission would establish principles and standards for supervision of derivatives-related activities. Joint legislation was also introduced that consolidated the two proposals but limited the scope of the legislation to banks. The Congress is likely to consider these issues in 1995.

Systemic Risk

Another Congressional concern appears to be that of systemic risk, the risk that a disruption in derivative markets may cause economy-wide repercussions. The concern is heightened by the global market linkages that have been created by the use of derivatives. Market linkages imply that shocks arising in one market may be transmitted to other markets as well.

In response to such concerns, the U.S. General Accounting Office (GAO) issued a report that examined various policy issues related to derivative markets.(5) The GAO report found "regulatory gaps" in the existing structure of derivative market regulations and recommended that the Congress bring the currently unregulated OTC activities of securities firms and insurance company affiliates under the supervision of existing financial regulators. As a long-term objective, the GAO also recommended that the Congress revamp and restructure the entire financial regulatory system to incorporate changes in the financial marketplace.

Disclosure

Another area of concern for the regulators is the need for sufficient disclosure on part of companies that maintain a derivatives portfolio. The SEC has been advocating increased disclosure on behalf of companies to inform investors of the underlying risks. The Financial Accounting Standards Board (FASB), an independent entity that establishes and interprets accounting rules, recently issued guidelines that require a complete disclosure by businesses on their use of derivative instruments. The FASB directive is applicable to businesses with assets exceeding $150 million.

Tax Issues

The tax treatment of derivative instruments could create economic inefficiency through two channels. First, transactions that achieve the desired economic results may not be entered into because of tax costs that may be disproportionately higher than the economic benefits. Second, tax motivated derivative transactions may also contribute to economic inefficiency by encouraging taxpayers to use complex and costly derivative instruments to produce after-tax results superior to simpler and inexpensive transactions. Asymmetries exist in the tax treatment of financial products based on character, timing, and the source of financial flows. Derivative instruments can alter the tax treatment of financial products by arbitraging tax asymmetries.

Excess Volatility and Securities Transaction Tax

Another policy concern is that of excess volatility introduced by the presence of derivative instruments. Some economists, including Joseph Stiglitz (1989) and Lawrence Summers (1989), both of who hold senior positions in the Clinton administration, have argued that the presence of irrational speculators is a source of increased volatility in the securities markets and a waste of valuable resources. They recommend a small securities transaction tax (STT) that would raise the transaction costs of trading. The chairman of the House Banking Committee, Rep. Henry Gonzalez, has also floated the idea of a STT on derivatives to curb the excessive use of such instruments. However, application of a STT could move trading to offshore markets because of increased international capital mobility. Campbell and Froot (1993) offer empirical evidence from Sweden and U.K. suggesting that trading volume in domestic markets is significantly reduced by the imposition of a securities tax.

CONCLUSION

Financial derivatives have grown rapidly in recent years due to improvements in computer technology, innovations in financial theory, and the need to manage risks arising from volatility in the interest and currency exchange rates. Derivatives are increasingly being used to manage various kinds of risk exposure, to obtain desirable financing, and to enhance investment and speculative opportunities.

The complexities of the derivatives markets are increasing every day, and it is important for the policy makers and regulators to understand these markets before hastily adopting any major legislative or regulatory changes. There are many unresolved policy issues relating to the derivatives markets that can only be answered by more data on these transactions.

FOOTNOTES

1 United States General Accounting Office, "Financial Derivatives: Actions Needed to Protect the Financial System," GAO/GGD-94-133, May 1994.

2 The Wall Street Journal, "Beleaguered Giant: As Derivative Losses Rise, Industry Fights To Avert Regulation," Thursday, August 25, 1994. The difference between the GAO and The Wall Street Journal estimate may be due to the exclusion of asset-backed securities from the GAO report.

3 See Smithson, Charles W. and Donald H. Chew, Jr. "The Use of Hybrid Debt in Managing Corporate Risk," Advanced Strategies in Financial Risk Management, edited by Robert J. Schwartz and Cliffored W. Smith, Jr., New York Institute of Finance, Englewood Cliffs, N J, 1993.

4 Derivatives: Practices and Principles. The Group of Thirty, Washington, D.C. July 1993.

5 United States General Accounting Office, "Financial Derivatives: Actions Needed to Protect the Financial System," GAO/GDD-94-133, May 1994.

Note: A list of references will be provided upon request to the author, Ernst & Young LLP, 1225 Connecticut Avenue NW, Washington, DC 20036.

Balvinder Sangha is a Manger with the Tax Analysis and Economics group of Ernst & Young LLP, Washington, DC. The views expressed in the paper are those of the author and do not represent the views of Ernst & Young LLP. This paper is adapted from one presented at the thirty-sixth Annual Meeting of NABE, Washington, DC, September 25-28, 1994.
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Author:Sangha, Balvinder S.
Publication:Business Economics
Date:Jan 1, 1995
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