9.5The use and abuse of derivatives

Derivatives, then, allow rms to hedge against erratic price and interest rate movements

while also attracting speculators because of their high gearing. These two aspects of

the market have led to conicting attitudes regarding their overall contribution to

nancial markets. Supporters of derivatives markets argue that they perform a number

of important roles. They are said to:

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Chapter 9

• Exchange rate risk, derivatives markets and speculation

l	facilitate the hedging of risk through sophisticated risk management, and by so doing reduce the cost of protection against risk;

l

be quicker to respond to new information than the cash markets, allowing people who do not participate in derivatives trading to forecast more accurately future cash market prices and thus to make better consumption, pricing and investment decisions – this is the ‘price discovery’ role of derivatives;

l	assist in the standardisation of commodity or nancial instrument contracts in the cash markets because derivatives contracts are highly standardised themselves;

l	contribute to the integration of global capital markets, hence improving the global allocation of savings and fostering higher investment levels;

l	help to combat the adverse effects of volatile commodity prices on the economies of developing countries because forward prices tend to be less volatile than spot prices, giving commodity producers an opportunity to reduce the volatility of the price of their output through hedging;

l	facilitate speculation, providing liquid markets and enabling hedgers to protect themselves from risk in the most efcient way possible.

Doubts have been expressed about the price discovery role since it assumes that

nancial markets are efcient – that is, that prices in these markets change immediately

to reect all new information coming to the market and that market agents are able

to interpret correctly the implications of this information for future developments.

However, the main doubts expressed about the benets of derivatives have centred on

the role of speculation and the difculties that the increasing complexity of derivatives

products have caused for regulators. Support for the attack on derivatives trading has

come from problems in markets as a whole and from examples of spectacular losses

by individual companies and banks.

For example, derivatives trading was widely held to be partly to blame for a

major stock market crash in 1987. The argument was that stock market traders were

pessimistic and expected a fall in the price of stocks when the exchanges opened after

a weekend. Large orders to sell arrived at brokerage houses prior to opening and,

as the market started falling, many traders automatically sold futures in the shares

of the major corporations. This destabilised stock markets and contributed to the

panic selling of stocks and shares. This view of the crash led to a general concern

that the derivatives markets might contribute to the volatility of the cash market.

The derivatives markets strenuously deny this, but worries have been expressed at

a high level. Towards the end of April 1994 nance ministers from the Group of

10 (G10) leading industrial countries agreed on the need to strengthen co-operation

in gathering statistics and assessing the implications for the world nancial system

of the innovative segments of nancial markets. There was also a call for improved

disclosure requirements and sufcient capital adequacy standards among nancial

institutions to underpin their risky activities. Capital adequacy requirements under

the Basel Accord (see Chapter 13) were modied to try to take the risks of derivatives

trading into account. They became part of the Capital Adequacy Directive, which

came into force in the European Union from the beginning of 1996.

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