Introduction:
Derivatives are a financial security with a value that is reliant upon, or derived from, an underlying asset or group of assets. The derivative itself is a contract between two or more parties, and its price is determined by fluctuations in the underlying asset (James Chen, 2019). I will start by explaining the two main uses of Derivatives. Firstly, using derivatives to hedge risk. Using derivatives for the objective of minimizing risk in the physical market. For example, a wheat producers (seller) and cereal manufacturers (buyer) hedging their exposure to fluctuations and wheat prices, since wheat is susceptible to significant fluctuations in price, owing to both supply and demand. Decrease in wheat price is a disadvantage for wheat producers as they receive less profit from crops. However, a decrease in wheat price is beneficial for cereal manufacturers as they receive one of their key factors of production at a discount. On the other hand, if wheat prices increase, wheat farmers benefit as they get more income in return for their crops while cereal manufacturers are at a disadvantage due to the increase’s costs.
In this paper, I aim to study the use of financial derivatives and if they played a role in the financial collapse or if it was just due to rogue trading. I will be identifying the transactions made, what went wrong and how this led to many losses. I will also be identifying the main contributing factor that caused the disasters.
Body:
Thus, wheat producers would like the price of wheat to be high while cereal manufactures want the price of wheat to be low. If wheat producers expect prices to fall and cereal manufactures expect prices to rise, both parties can enter into a contract to fix the future price at which the wheat will be sold, example setting the price at £10 for six months regardless the price fluctuations. In this case the wheat producer is protecting himself from an expected decrease in price of wheat while the cereal manufacturer is protecting himself from an increase in price of wheat. If price falls, the cereal manufacturer would wish he hadn’t signed the contract as he could be buying wheat at a cheaper price. Conversely the wheat producer would wish he hadn’t signed the contract as he could be selling wheat at a higher price, thus increasing his income. This is a zero-sum game since the price of wheat can only move in two directions, up or down, possessing both a distinct winner or loser. So, either the interest of only the wheat producer or the cereal manufacturer can be met, not both. In this example, a forward contract was used by both the buyer and the seller in an effort to hedge price risk by locking in the price of wheat, thus showing that derivatives are useful as they can be used to hedge risk. Secondly, speculating on derivatives. Speculation on derivatives is motivated by profit, rather than a desire to mitigate risk. The main difference between Hedgers and Speculators is that, Hedgers seek to limit risk by using derivatives as insurance policies which indirectly increases profitability, while Speculators are directly driven by the opportunity for profit.
There are many classes of derivatives with the four main types being; Forwards, Futures, Options, and Swaps (Gunther 2013). Overall, these permit the price of buying or selling a specific amount of the underlying asset to be set beforehand, which is why they lead to deep concern and are usually described as “wild beasts” (Steinherr, 1998) or as Warren Buffet described them as “weapons of mass destruction” (Gunther 2013). Derivatives are extremely profitable for banks as the greatest margins are in the operations which involve high added value. For example, in 2009 U.S. commercial banks produced a high of $22.6 billion in derivatives trading revenues according to a survey of 1,030 federally insured banks by the Office of the Comptroller of the Currency (Gunther 2013).
Benefits of Derivatives:
Derivatives have many benefits; Firstly, all derivative transactions take place in the future as it provides people with better prospects, secondly, people can carry out massive transactions with tiny amounts, thus giving the advantage of leverage allowing less well-off individuals to enter the market. In addition, as the contracts are very liquid and less costly, intraday traders enjoy the advantages of liquidity and less brokerage in comparison to the cash market. Finally, it helps with risk management and if used correctly can aid to producing benefits for its handler and good results. Even complete markets find derivatives beneficial as investors, in order to avoid the duplication of several payoffs, face high transaction costs. It also helps them expand their stock portfolios (Gunther 2013). Derivatives change the amount of public information and, in turn, the price setting process. Easley, O’Hara and Srinivas (1998) and John, Koticha, Narayanan and Subrahmanyam (2000) concluded that presenting derivatives leads to an enhancement in the quantity of information about stock prices. Rivas and Ozuna (2006) carried out a study to see if derivative usage increased bank efficiency in Brazil, Chile and Mexico (Mutende, 2010). Regression analysis was used on a variable representing derivative usage and control variables were used to demonstrate the efficiency scores (Mutende, 2010). Dummy variables, DERIVATIVE, which was assigned the score of 1, if derivatives were used, otherwise 0 (Mutende, 2010). The results concluded that derivative user banks had a higher efficiency score to their counterparts and that regulatory bodies like the government and institutional restrictions adversely affected the efficiency levels of these banks (Mutende, 2010).
Drawbacks of Derivatives:
On the other hand, derivatives are not always a good thing for a couple of reasons. Leverage is a sword pointed in both directions and in case it’s not gotten accurately, you end up trailing a large sum of money as derivatives have precise maturities and, on that date, they terminate unlike other assets such as cash where stocks can be held onto for long. Derivatives have also been blamed for enormous falls by critics which keep occurring after their introduction and many individuals say that it increases speculation which is bad for small retail investors who hold the stock market together. Furthermore, it is complicated as numerous tactics of derivatives can be employed only by a professional and for a layman this a challenging task to complete so it limits its application. A couple of disasters which were caused by derivatives are: Long-Term Capital Management (LCTM) fell apart with $1.4 trillion in derivatives in their accounts which resulted in the US dollar fixed income market freezing (Dodd, 2005). The Japanese bank Sumitomo used derivatives in their manoeuvring of the international copper market in the 1990’s (Dodd, 2005). Barings Bank was abruptly brought to bankruptcy by over $1 billion as a result of losses from derivatives trading (Dodd, 2005). Enron crumpled in 2001, which was the largest bankruptcy at the time, leading to collateral damage throughout the whole energy sector (Dodd, 2005). In 2002, the Allied bank lost $750 million trading in foreign exchange options (Dodd, 2005). Both the Mexican crisis of 1994 and the East Asian crisis of 1997 were aggravated by the use of derivatives to take huge positions constituting the exchange rate (Dodd, 2005).
The Derivative case of Baring: (1890 & 1995):
The Barings Case involves the crisis of 1890 and the crisis of 1995. In 1890, Baring’s liquidity took a turn for the worst which is why they asked for a loan of 800,000 (Körnert, 2003). In the following weeks, the situation worsened when the Russian state wanted to withdraw its deposits of 3 million pounds which made the situation so bad it was forced to borrow (Körnert, 2003). Baring’s was in deals with a British company at the time with whom they agreed to purchase 1.5 million worth of stock but as a result of this, they informed the governor of the bank of England who aided to bail them out which resulted in saving Barings and stopped further bank failures in London (Körnert, 2003). The crisis of 1890 played a key role in analysing the domino effects on banks. The slow servicing Argentina loans showed Barings to a huge repayment risk. To prevent illiquidity, securities in the US were sold on a colossal level (Körnert, 2003). The Crisis of 1995 was one of the biggest ones as Baring Group consisted of over 100 companies and it was BFS which was responsible for the crisis (Körnert, 2003). Leeson was involved in activities, which were, on some cases unauthorised. BFS was authorised to trading activities in Nikkei futures and carry out own account trading in the form of inter-exchange arbitrage (Körnert, 2003). At no point was BFS authorised to trade in options of its own account or buy/sell futures other than within the inter-exchange trading arbitrage, but this unfortunately happened. These activities caused losses which led to Barings being placed in administration due to insolvency (Körnert, 2003). Ernst & Young, Baring’s administrators had reached an agreement on the takeover of Baring for 66 million pounds. The losses snowballed over 2 years and by the time Baring was liquidated, they had risen to 927 million pounds (Körnert, 2003). However, its balance sheet differed as it did not consider the losses which has already taken place from the individual financial derivative operations of Nikkei futures, Japanese state bond futures and Euroyen futures. One explanation why Leeson bought futures contracts could be that he was expecting a rise in the stock price of Nikkei or to soothe out the losses on his option transactions (Körnert, 2003). If the stock prices had risen, Leeson would have been able to request delivery of the Nikkei futures at the price decided when recording the transactions and then sell them for the higher market price prevailing at the time (Körnert, 2003). However, the stock prices fell, he sustained losses which were responsible for BFS and the Baring Group. The Bank of England also underwent a few changes after the Baring Crisis. The head of supervision left the bank, the SWOT analysis method to assess risk was changed and replaced by a new model called RATE (Risk, assessment, Tools of supervision and Evaluation) (Körnert, 2003). In Germany, the Federal Bank issued ‘Minimum requirements for the trading activities of credit institutions. The Crises did not blowout to the entire banking system via the domino effect as it was limited to a single case of a fraudulent and rogue trader (Körnert, 2003).
Conclusion:
Quoting Warren Buffet, “In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” Derivatives may not directly impact the market volatility but as seen from the Baring’s case, they do not come without risk for financial constancy. Financial Derivatives can lead to the domino effect as they unexpectedly disrupt the economy in the long term as more money is being injected which can lead to long term losses for firms and collectively for the state. As seen in Baring’s case, it did not lead to a domino effect as it was the cause of a fraudulent individual, however, usually such cases would be spread over a greater magnitude. In the short term helpful, but in the long term disruptive as firms are not able to maintain their spending patterns. Derivatives are helpful but also dangerous, depending on the market’s situation, the state of the economy and regulations imposed by the government and other institutional bodies.
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