Risk Transfer

Derivatives in Theory and Practice

Christopher L. Culp

• Publisher: Wiley
• Year: 2011
• Print ISBN: 9780471464983
• eBook ISBN: 9781118160886
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

Based on an enormously popular "derivative instruments and applications" course taught by risk expert Christopher Culp at the University of Chicago, Risk Transfer will prepare both current practitioners and students alike for many of the issues and problems they will face in derivative markets. Filled with in-depth insight and practical advice, this book is an essential resource for those who want a comprehensive education and working knowledge of this major field in finance, as well as professionals studying to pass the GARP FRM exam.

Christopher L. Culp, PhD (Chicago, IL), is a Principal at CP Risk Management LLC and is also Adjunct Professor of Finance at the University of Chicago. He is the author of Corporate Aftershock (0-471-43002-1) and The ART of Risk Management (0-471-12495-8).

PART ONE

The Economics of Risk Transfer

CHAPTER 1

The Determinants of Financial Innovation

The range of financial products and instruments available today is quite literally mind-boggling. Corporate securities no longer include only plain-vanilla stocks, bonds, and convertibles, but all manner of preferred stock, commodity- and equity-indexed debt, amortizing principal notes, and more. Depository instruments, once limited to fixed-interest demand and term deposits, now encompass products that pay interest based on stock market returns, election results, and other eclectic variables. And with the advent of alternative risk transfer (ART), insurance solutions now transcend their traditional role and provide indemnity against risks like exchange rate shifts, credit downgrades, and investment losses.

Perhaps nowhere has the sheer breadth of financial products grown more than in the area of derivatives activity. The conventional definition of a “derivative” is a bilateral contract that derives its value from one or more underlying asset prices, indexes, or references rates.1 As we will see again throughout the text, the definition of derivatives that will prove most useful for our purposes is a contract for the purchase or sale of some asset (or its cash equivalent) in which time and space are explicitly defined and differ in some way from the here and now.

The most common types of derivatives include futures, forwards, swaps, and options, all of which are available on a huge range of underlying assets (e.g., metals, interest rates, electric power, currencies, etc.) and for maturities ranging from days to many years. The terms of these agreements can be so customized and varied that the array of products available to their users is essentially boundless. In addition, derivatives are frequently embedded into other products like bonds to create instruments like commodity-linked debt.2

Many public and social commentators have questioned whether all of these diverse financial products available today play a legitimate economic function. Or, even if most new financial products do serve some purpose, how big is the benefit and who appropriates it? The question is rather like asking how badly society really needs another breakfast cereal in the grocery aisle—one more surely cannot hurt, but how much does it really help?3

To understand the benefits and functions of derivatives, we need to begin with a broader discussion of the functions of the economy in general and financial markets (as distinct from physical asset markets) in particular. We then consider what determines the rate and types of financial innovations that emerge to help provide the functions of the economy and the financial system.

THE ECONOMIC AND FINANCIAL SYSTEMS

Academics have advanced a number of hypotheses to explain the range of financial instruments available and the rate at which they are developed, but remarkably little common agreement has been reached on which explanation is most consistent with the data.4 One explanation must surely be that not all innovations occur for the same reason. As a result, the historical data available to test competing hypotheses for explaining innovation is too limited relative to the multiplicity of possible explanations that the data reflects. Indeed, we can identify anecdotal examples that are consistent with virtually all of the proposed theories.

The overarching theme underlying most explanations for legitimate financial innovation is the idea that financial products arise to help perform the functions of the economic system. Products like derivatives, in turn, are generally considered part of the financial system, the component of the broader economic system that provides a well-functioning capital market.

The Economic System

Economic behavior includes all the actions taken by humans to achieve certain ends when those objectives are in the face of scarce means with numerous potential uses. An economic system, in turn, is a social mechanism to help humans address those resource scarcity problems. Knight (1933) argued that any properly functioning economic system must perform five main interconnected functions.5

Fixing Standards

The economic system should “fix standards” for the purpose of maximizing the efficient allocation of resources. An economic system must somehow allow a heterogeneous group of individuals and firms to coordinate their activities with one another using a common and consistent set of indicators about the value of scarce resources. This is the classic rationale for a free price system—to signal relative scarcity on the supply side and the intensity of consumer wants and needs on the demand side (Hayek, 1945).

Allocation

The economic system should actually facilitate the allocation of those scarce resources to their most highly valued uses. In a capitalist system, the counterpart to the free price system—which serves to indicate relative scarcity and the value of alternative resource allocations—is free trade. By facilitating the exchange of assets and goods at freely determined prices, resources may actually flow from their original endowments to those individuals and firms that value those resources the most.

Distribution

The third function of an economic system is distributional. The free price system and open markets together help ensure that resources are allocated to their most highly valued uses. This in turn generally leads to efficiency, or the situation in which social resources are collectively the greatest. Distribution then may seek to reallocate those resources based on the particular wants and needs of certain consumers and producers. To repeat a common analogy, allocative efficiency helps ensure that the social pie is baked as big as possible. Once the size of the pie is maximized, distribution then seeks to determine the size of each pie slice.

Maintenance and Accumulation of Factors of Production

An economic system should promote the maintenance and efficient accumulation of factors of production. Specifically, an economic system should support the growth of population and the labor force relative to basic resource constraints (i.e., to avoid the Malthusian trap). In addition, the system should facilitate the processes of capital formation and capital accumulation, where “capital” may be taken to mean any factor that facilitates production over a period of time (Hicks, 1939).

Ensuring Consistency in Short-Term Plans

Finally, the economic system must reconcile consumption and production plans over short periods of time. The system thus must serve a coordination function to keep the consumption and production plans of a huge number of different individuals and firms consistent with one another.

The Capital Market and the Financial System

Derivatives and other financial products are part of what we call the capital market, a specific component of a broader economic system whose particular function is facilitating the allocation and distribution of resources across space and time. Interspatial resource allocation and distribution involve the shifting or transfer of resources between different places or among different economic agents, whereas intertemporal resource management involves the movement of resources across periods of time. Consumption smoothing, for example, is the process by which economic agents reduce consumption in plentiful periods in order to prevent consumption from dipping too far during periods of want. Similarly, as Part Two explains in detail, inventory management is essentially the borrowing and lending of physical commodities over time.

Like all the basic functions of the economic system, intertemporal and interspatial resource allocation is strongly interconnected with the other functions of the system. In that sense, the capital market does not play a completely unique role, except to the extent that capital itself as a factor of production is unique.

Providing a mechanism for interspatial and intertemporal resource management, however, is no small task. An organized financial system thus is generally required to enable the capital market to perform its allocative and distributional functions. The financial system includes a combination of institutions, markets, and financial products that together provide a payments system, a mechanism for the pooling of capital to facilitate investment, and the provision of information that facilitates coordination and resource allocation6 (cf. Merton, 1992, 1995a, 1995b). In addition, a critical function of the capital market and the financial system is providing economic agents with a formal mechanism for controlling their exposure to randomness—that is, the management of risk and uncertainty. In particular, the financial system should facilitate efficient risk bearing, risk sharing, and risk transfer.

“BENEFICIAL” AND “SUCCESSFUL” FINANCIAL INNOVATION

Miller (1986) distinguishes among an innovation; a successful innovation; and a successful, significant innovation, all of which are separate from a mere improvement. In order to be an innovation rather than an improvement, the financial product must arise or evolve unexpectedly. Technological change, for example, often gives rise to new products that can be considered improvements, but not really innovations. Innovations, in short, cannot be forecast.

A successful innovation is any innovation that “earns an immediate reward for its adopters,” whereas a “successful and significant innovation” must cause a permanent and lasting change to the financial landscape (Miller, 1986, p. 461). To Miller, innovations that are both successful and significant “manage not only to survive, but to continue to grow, sometimes very substantially, even after their initiating force has been removed” (Miller, 1986, p. 462).

Most successful and significant innovations help provide one or more of the functions of the capital market in particular and the economic system in general. The discontinuation of a new financial product, in turn, likely indicates that particular innovation had at best a marginal long-term role to play in the economic system. But that hardly means the innovation was pointless.

A well-functioning capitalist economic system relies on trial and error. Successes and failures of market participants thus are normal characteristics of progress—you cannot have one without the possibility of the other. As a result, we should not expect all financial innovations to be successful ex post, despite all good intentions of the designers ex ante. As an example, four out of every five new futures contracts are delisted within a few years of their introduction (Carlton, 1984). Innovation thus must be regarded as evidence of what Schumpeter calls the “creative destruction” of capitalism. It is a necessary component of progress.

THE TIMING OF INNOVATION

The universe of financial products available in the capital market at any point in time may generally be classified in one of Miller’s three categories—as an unexpected improvement (i.e., an innovation), a successful innovation, or both a successful and significant new product. But apart from this snapshot of the capital market at any point in time, Miller’s taxonomy also implies certain drivers affecting the timing and rate of financial innovation. We consider here some of the most common factors that are believed to explain exactly when new financial products are most likely to emerge.

Taxes and Regulations

To Miller (1986, 1992), the impulses that are most often responsible for innovation; successful innovation; and successful, significant innovation are changes in taxes or regulations. Consider some of the examples he offers, such as the Eurodollar market or the market in which commercial banks borrow and lend in dollars offshore. This market arose as a fairly direct response to Regulation Q, which specified a maximum interest rate payable on domestic time deposits without placing a similar ceiling on foreign dollar-denominated time deposits. Similarly, a 30 percent tax on interest payments from bonds issued in the United States to foreign investors gave rise to the development of the Eurobond market, in which dollar bonds issued abroad to foreign investors were exempt from the special tax. And so on.

Miller also explains that a surprisingly large number of lasting and significant innovations in derivatives have been a result of liberalization or clarification in the relevant regulations and laws governing derivatives and comparable transactions. As an example, until the 1970s most derivatives involved the physical delivery of the asset on which the price or settlement value of the contract was based. But “cash settlement” became popular in the 1970s as an often cheaper alternative to physical delivery. As the discussion later in Part One clarifies, cash settlement simply means that instead of the short delivering a physical asset to the long, the s...

Table of contents

• Cover
• Contents
• Title
• Copyright
• Acknowledgments and Dedication
• Preface: The Demonization of Derivatives
• Introduction and Structure of the Book
• Mathematical Notation
• Part One: The Economics of Risk Transfer
• Part Two: Derivatives Valuation and Asset Lending
• Part Three: Speculation and Hedging
• Part Four: Appendixes
• References
• Index