Since the development of the Black-Scholes model in 1973 and rapid improvements in technology, financial derivatives have become increasingly popular. Today, derivatives are seen as major attributes of financial markets around the globe. Derivatives are becoming more common amongst financial and non-financial institutions along for investors. As economies around the spectrum continue to emerge, financial derivatives are expected to grow, but what are the implications of this? This article uncovers as to why financial derivatives are useful, but how they are also lethal.
A derivative is essentially an instrument that derives the future price of an underlying asset, i.e. commodities or equities, based on information such as a spot price and interest rates. The three main types of derivative contracts seen within financial markets include forward contracts, swaps and options. The phrase plain vanilla is often used to represent such contracts. For instance, forward contracts involve transactions that must occur at a set price and date, with swaps consisting of a subset of forwards. Conversely, a more complex form of derivatives is known as exotic, which depends on a defined set of assets.
Why are financial derivatives useful?
The foundations as to why financial derivatives are useful are based around the idea of increasing returns mainly through reducing costs and uncertainty that may lie amongst investors. As a result, derivatives form a complete or near to complete system of markets that is effectively frictionless.
Derivatives are used as a financial tool to improve risk management, which in turn poses great benefits to financial markets. With this, individuals and businesses are likely to take on riskier, but more profitable activities through hedging. Hedging would minimise any possible losses that could occur from fluctuating prices in money-markets. The end result would involve a much more productive and efficient market system.
Secondly, derivatives enable investors to trade on information that would usually be expensive to trade on. For example, without derivatives, the short sale of securities is an extremely difficult and risky procedure. Following this, the rate at which harmful information regarding stock prices circulates around the market would be much slower, thus reducing market efficiency. Financial derivatives overcome this by providing inauspicious price information of stocks at a lower cost and so boosting productivity. However, at the same time, external factors that may hamper and create price volatility could reduce the significance of the use of derivatives.
Overall, each benefit of financial derivatives will aim to create an equilibrium set of prices, which in turn creates market efficiency. More so, financial derivatives are only useful if investors fully understand the instrument along with any possible risks associated. If this is not the case, the uses of derivatives could start to decline, with the dangers of the instrument increasing consequently.
The dangers of derivatives
When it comes to considering the issues of financial derivatives, the actual instrument is often not to blame. Indeed, derivatives can be complicated and so they do require well trained individuals to work with them, but this is easier said than done. The reason for this is due to larger organisations valuing a numerous amount of derivatives, which would include some exotic contracts. Following this, once you work with complicated derivatives, it is difficult to break loose from them, which causes complications.
For example, Germany’s global investment bank, Deutsche Bank has been a culprit of this, despite being the world’s largest holders of derivatives. During the financial crisis, the German giants were accused of overstating the value of advanced derivatives and so were fined an amount of $55 million. Overstating the value of derivatives would increase its value, but provide incorrect and misleading information for investors, as was the case with Deutsche. However, the bank felt that there were no guidelines and a lack of regulation when it came to measuring the risk of derivatives, at the time of the crisis. Working with advanced derivatives is a risk in itself, which causes more issues to individual firms than financial markets.
In some aspects, derivatives are a gamble. When derivatives are used for hedging, the institution might become less risky itself, but it can also face a great level of risk. A major issue with derivatives is that certain aspects of the risks are misunderstood or not taken into account dearly. This was the case for clients that purchased swap derivatives with former investment bank, Lehman Brothers. When the financial firm had filed for bankruptcy in 2008, such clients were surprised to be left with only unsecured claims and not the collateral they had posted. However, at the same time it can be said that derivatives are a form of gambling that can provide wins for investors, but also strengthening market efficiency.
Another type of derivative, over-the-counter (OTC) contract can impose some dangers. There is often a lack of market transparency with OTC derivatives, which can form uncertainties with regards to any build up of risk. If the lack of transparency increases to a greater extent, then it could reduce incentives to trade when a market is declining. As a result, market liquidity could be negatively impacted and so causing the prices of assets to fluctuate.
Derivatives allow individuals and firms to make greater returns that may be difficult to achieve or at a greater cost than without derivatives. Overall, financial derivatives are lethal if they are used in a speculative manner. However, the benefits of derivatives are much greater than the risks they may pose to financial markets. As derivatives have been around for a long time as well as being studied to great lengths, it is unlikely that they would impose major financial risks. Any dangers that derivatives pose on an individual firm are not likely to spread into an entire financial market. As long as financial derivatives are managed and operated sufficiently, they would provide more financial rewards than chaos.