Financial Derivatives

A Blessing or a Curse?

Simon Grima, Eleftherios I. Thalassinos, Rebecca E. Dalli Gonzi, Ioannis E. Thalassinos, Eleftherios I. Thalassinos

• Publisher: Emerald Publishing Limited
• Year: 2020
• Print ISBN: 9781789732467
• eBook ISBN: 9781789732474
• Topic: Business
• Subtopic: Corporate Finance
• Index: Business

Financial Derivatives have long been the subject of conflicting views. For some, they are a useful instrument, too often maligned by those who do not understand them; for others, they are a complete waste of time and money. But which is it? Should we embrace financial derivatives, or fear them? 

In Financial Derivatives: A Blessing or a Curse? Simon Grima and Eleftherios I. Thalassinos rigorously explore the theory and debates surrounding this controversial topic. First exploring the perceived problems and the uses of derivatives, they study and evaluate the people who use financial derivatives; the impacts of derivatives use; and examples of safe use of derivatives. Looking at real-world examples, Grima and Thalassinos include public case studies on financial firms such as Barings Bank PLC, Allied Irish Bank, and Société Générale, as well as non-financial firms including Metallgesellschaft AG and Enron. Through these case studies, the roots of firm failure and large losses become clear, asking whether it is the misuse of this financial instrument, rather than the derivatives instrument itself, that is the cause. 

For students and researchers in finance, or practitioners involved in trading, regulating, or auditing, this is a fundamental text exploring a controversial and relevant concept.

Chapter 1

The Perception on Financial Derivatives: The Underlying Problems and Doubts

This opening chapter introduces derivatives and the debates surrounding their use. It highlights the scope for this book, provides the objectives, the intended contribution, presents the problem and discusses some questions and curiosities surrounding their use. Moreover, previous studies carried out on derivatives are summarised herein.

1.1. Overview

Edington (1994) sees the opinions on derivatives as two opposing camps: ‘those who embrace them as the “Holy Grail” of the new investment era, and those who denigrate them as the financial Antichrist’. As this quote suggests, there are many conflicting views and opinions on derivatives and their use. Derivatives are seen either as useful instruments or as a complete waste of time and money (Dodd, 2002b). As defined by Hull (2008), derivatives are any ‘financial instruments that derive their value from the value(s) of other, more basic, underlying variables’. The underlying can be anything, for example, a financial asset or a rate, with payments that are linked to an index, the weather in a specific region or the profitability of selected companies (Stulz, 2005).

Stulz (2004) in his paper ‘Should We Fear Derivatives?’ specifies ‘two types of derivatives: plain vanilla and exotic’. Plain vanilla derivatives are forward and future contracts, swaps, options or a combination of these. Exotic derivatives are all other remaining derivatives. These will be described in more detail in the second chapter.

‘A Chronology of Derivatives’, by Chance (1995), focuses on the history and development of derivatives. He notes that the start of derivatives came about at around 580 bc, ‘when Thales the Milesian, purchased options on olive presses and made a fortune off a bumper crop in olives’. According to Chance, in 1700 bc, Jacob (Bible, Genesis chapter 29), ‘purchased an option, at a cost of seven years of labour, that granted him the right to marry Laban’s daughter, Rachel’. Chance identifies key historical moments in the derivatives development: the very first derivatives exchange was the ‘Royal Exchange in London’, where forward contracts were carried out. The first ‘futures’ contracts are said to have been executed in the 1650s in Osaka on Japan’s Yodoya rice market. Chance notes that the next most important ‘event happened with the formation of the Chicago Board of Trade in 1848’.

In another paper, ‘Demystifying Financial Derivatives’, Stulz (2005) notes that until the 1970s, the derivatives markets were not always so large. However, the changes in the economic climate and the advances in the pricing methodologies of derivatives led to spectacular growth. During that period, the instability of ‘interest rates and currency exchange rates increased sharply, making it crucial to find ways to hedge the relative risks more efficiently. Meanwhile, deregulation in a variety of industries, along with soaring international trade and capital flows, added to the demand for financial products to manage risk’. According to Stulz (2005), the development, in the early 1970s of the Black-Scholes formula and technology innovations which enabled faster and more efficient management of computations, stronger network and communication infrastructures, changed trading of derivatives drastically. Thereafter, financial engineers could build new derivative products and find their value more easily.

The market for derivatives, according to the Bank for International Settlements (BIS) Quarterly Review (2019), in the first half of 2018 stood at a notional amount of outstanding of all types of over-the-counter (OTC) derivative contracts of US$544.4 trillion at the end of June 2018 (gross market value of US$9,662 billion). Although large, this was a slight decline from end-June to end-December 2018, of approximately US$50.6 trillion.

Exchange-traded futures and options derivatives, however, measured by notional amounts, stood at US$39 trillion and US$68.2 trillion as at December 2018 (BIS, 2019).

Therefore, there is a considerable need to further understand and contribute to the scholarship on derivatives. Moreover, the large and variable market size necessitates controls that are constantly kept up to date in order to prevent a potential global financial crisis started by this instrument.

As we shall see in the next chapters, experience has indicated that derivative products have transformed the way firms view financial risk and mitigate it. It is no longer relatively simple and risks are changing continuously with innovation. Risks are no longer nationwide but global and the internet and other fast communication channels have further complicated the issue. In her article, ‘Are Derivatives Financial “Weapons of Mass Destruction”?’ Simon (2008) explains that although derivative instruments have been used to hedge risks that were previously left open, there are still those who are sceptical about using these instruments. As the Group of Thirty (G30) (1993) note, users from ‘both inside and outside of the financial industry, remain uncomfortable with derivatives activity’. Moreover, over the years, we have seen a widespread increase in employment of derivatives with adequate risk management systems. Nevertheless, not all firms are immune to derivatives misuse.

In Philippe Jorion’s (1995, p. 4) ‘Big Bets Gone Bad’, he recites the words of a Wall Street wise man Felix Rohatyn, who described derivatives as ‘financial hydrogen bombs created by 26 year-olds with computers’. He notes the description given to derivatives ‘a monstrous global electronic Ponzi scheme’, by Henry Gonzalez, former House Banking Committee chairman. In a March 1995 broadcast of the CBS TV show 60 Minutes, derivatives were depicted as ‘too complicated to explain but too important to ignore’. This show suggested that derivatives are ‘highly exotic, little understood and virtually unregulated. Some people believe they are so unpredictable they could bring down the world banking system’ (Jorion, 1995, p. 4).

Hull (2008) highlights that the perception of derivatives as inherently bad financial instruments which have led to large financial failures of companies and government institutions. However, according to Cochran (2007), the understanding of the concept of derivatives – ‘which most economists view as a positive innovation that emerged over the past 30 years’ – is a predominant factor in the global financial markets. Since many derivatives involve cross-border trading, ‘the derivatives market has brought increased international financial fragility and the attendant need for greater supranational governance of the instrument’ (McClintock, 1996).

Becketti (1995) notes the popular belief that firm-specific risk and systemic risk are increased by derivatives use and perceived to have threatening effects on both the real sector and the financial system. Firm-specific risk includes ‘credit or default risk, legal risk, market and liquidity risk, operating or management risk’.

He highlighted further that the greater competition and interconnectedness between the financial institutions (both credit institutions and non-credit institutions) and financial markets, the increasing concentration of derivative off balance sheet trading resulted in reduced transparency in disclosure of information have intensified reactions to market disturbances.

Warren Buffett (2003), as noted by Simon (2008), describes derivatives in the Berkshire Hathaway Inc. 2002 Annual Report as being ‘financial weapons of mass destruction and contracts devised by madmen’. An article by Das (2005), ‘Traders, Guns and Money’, highlighted that ‘ever since Warren Buffett memorably described derivatives as ‘financial weapons of mass destruction’ there has been a thriller waiting to be written about them’.

Following the numerous cases of losses where derivatives have been used, the question is whether derivatives and their markets are the real culprit that brings about large failure and the losses by companies and government entities. Some of these cases are summarised in the following chapters. Table 1.1 lists a summary of some of the renowned trading losses ever, highlighted in literature. It demonstrates the trouble that these derivatives instruments are perceived to have brought to the economy and the losses derived from their use. All, except for a few (such as Daiwa Bank in 1995), have involved the use of, and trading in, derivatives. In addition, just to give a perspective of the losses, we added the percentage of the total losses as summarised in this table. Moreover, Barth and McCarthy (2012) note in their article, ‘Trading Losses: A Little Perspective on a Large Problem’, when seen through the lens of relative size relative to the net equity, the losses of, for example, Amaranth Advisors and LTCM and at the Investment bank Barings were nearly equal to or exceeded those firms’ net equity and pushed all the three into or close to insolvency.

Table 1.1. Summary of Trading Losses.

Source: Compiled by the authors.

Babak (2008) in his article compares trading derivatives to ‘juggling running chainsaws, which also happen to be on fire’. He notes ‘unless you know what you’re doing, it will get messy’ and that all these losses started out as small loss but ‘were allowed to balloon into grotesque proportions’. Moreover, if we allow our convictions to overrule our discipline, we’re headed towards the same fate.

If anything, such gigantic losses should dampen conspiracy theories of market manipulation. After all, if someone can’t bully a market with a few billion, then the market is indeed bigger than anyone and everyone.

Adams and Runkle (2000) take a slightly different line, arguing that it is the complexity of derivatives not their inherent nature that should be seen as a contributory factor to the losses and failures. Muehring (1995), alternatively, suggests that it is neither the inherent quality of derivatives nor their complexity that causes major losses and that these are not a necessary element of mismanagement. He explains that most times this can result from a ‘can’t-lose mentality’ which fails to take note of the downside of the investment.

Das (2005) sees the ‘world of derivatives trading as a world of beautiful lies’, where the trading floor is broken down into salespeople,

who lie to clients, traders who lie to sales and to risk managers, risk managers who lie to people who run the place (or as it is sarcastically noted in this article – only think that they run the place); the people who run the place lie to shareholders and regulators, the quants (sarcastically described as fabulous rocket scientists) develop a model for lying and lastly the clients, they lie mainly to themselves.

As Stulz (2005) suggests, that derivative contracts have only made the headlines when they led to large financial losses. As noted, derivatives have been linked to notable events ranging from financial to non-financial firms, countries and counties. Nevertheless, properly handled derivatives have been very precious to current economies and will definitely remain so.

In order to determine whether it is misuse of this financial instrument, and not the derivatives instrument itself, that causes firm failure and large losses, the pertinent derivatives’ cases of misuse need to be reviewed further. These cases will help to identify some of the root causes of these incidents. Moreover, one must look deeper into aspects such as the environment surrounding their use and the characteristics of the people using them. One must not look at these cases in isolation. There are also cases of derivative use that have not resulted in loss or failure and so have escaped publication or media. The authors have also reviewed research studies, interviews and surveys about derivative misuse to help mediate between them and the condemning and condoning derivatives usage reports. They compared the findings to specific studies by Bezzina and Grima (2012); Bezzina, Grima, and Falzon (2013); Grima, Romanova, and Bezzina (2017); and Grima (2012) that u...

Table of contents

• Cover
• Title
• Chapter 1 The Perception on Financial Derivatives: The Underlying Problems and Doubts
• Chapter 2 Financial Derivatives Use: A Literature Review
• Chapter 3 A Thematic Analysis and a Revisit to Literature on Cases of Improper Use of Derivatives
• Chapter 4 The Financial Derivatives Myths and Doubts: A Conclusion
• Appendix: Summary of Cases
• References
• Index