9.6 Summary

the Financial Times of 26/27 September 1998, ‘all the complex formulae and computer

models that the best brains had produced simply did not work when nancial crisis

spilt over from the emerging markets’.

LTCM was, in the event, rescued by the New York Federal Reserve, which recruited

fourteen nancial groups to help. Prior to the rescue there were genuine fears that

LTCM’s collapse would have led to the collapse of a large number of major world

banks. Even with the rescue, UBS, Europe’s largest bank, had to accept a loss of

£406 million.

Since 1998, there has been a dramatic increase in the number and size of hedge

funds and some concern has been expressed about their role and possible impact

on international nancial stability. In May 2006, the European Central Bank in its

Financial Stability Review suggested that hedge funds had created a major risk to global

nancial stability. The article placed the collapse of a key hedge fund or a cluster

of smaller funds in the same category as a possible bird u pandemic in its ability to

trigger widespread disruption in nancial markets. The ECB was particularly worried

by the herd instinct among hedge funds and their tendency to mimic the strategies

followed by others.

9.6Summary

Exchange rate risk takes several forms and, in the absence of xed exchange rates or

monetary union, rms must take action to protect themselves against that risk. The

need for sophisticated risk management in the face of highly volatile exchange rates

provides one of the principal reasons for the growth of derivatives markets. These

allow rms to hedge risk by taking out contracts in derivatives markets, which carry

the opposite risk to that which they face in the underlying markets such as the

forex markets. The two principal types of derivatives are futures and options. Both

are tradable contracts offered by futures markets. Futures promise the delivery of an

underlying asset of a specied kind on a given date, although delivery is seldom made.

Options give the right to buy and/or sell an underlying asset, although that right

need not be taken up. In order to increase tradability, both futures and options are

highly standardised. Both offer the possibility of very high rates of prot. Futures do

this through the system of margin payments. In the case of options, this occurs because

buyers of options pay only the premium for the right to trade at the specied price.

Financial futures and options contracts are offered in relation to exchange rates,

short-term and long-term interest rates and stock exchange indices. They are widely

used for speculation as well as for risk management. In recent years, options have

become extremely complicated, with new forms of options contracts appearing

regularly. The more complex and less common types of options are known as exotic

options. Exchange-based options and futures are cheaper and more liquid than OTC

products, but OTC products can be designed to meet the specic requirements of

each client. Forward contracts are available on a much wider range of currencies than

exchange-traded futures and options. There may also be important cash ow differ-

ences between forward forex contracts and options. Forward and futures contracts

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Chapter 9 • Exchange rate risk, derivatives markets and speculation

are likely to provide cheaper protection against loss than options, but remove the

prot opportunity if prices move in favour of the rm. Thus, options are generally

preferable if the hedger is uncertain about the direction the price of the underlying

asset is likely to move. A hedger who is condent about the direction in which the

price will move is more likely to choose forward or futures contracts or remain in an

open position and accept the risk of a price change.

Derivatives markets have been controversial in recent years. Many rms have

lost badly in these markets and fears have been expressed that mismanagement in

derivatives markets could cause serious problems for the international nancial

system. This danger must be set against the several advantages offered by derivatives.

The question remains as to whether the extra protection provided by the derivatives

markets increases the systemic risk.

Questions for discussion

1	Consider the relative advantages and disadvantages of using forward contracts, futures contracts and options as means of speculation.

2	How do futures markets seek to protect themselves and their clients against default risk?

3	Consider the following statement:

A speculator who felt that interest rates were likely to rise or a currency’s value

decline would go short in the relevant asset by selling a futures contract.

(a)	Why would a speculator go short rather than long in these two cases?
(b)	What does going short in interest rates mean?
(c)	How does selling a futures contract allow one to go short?

4

The text suggests that it is not very likely that sterling would fall from £1 $1.80 to £1 $1.70 in a single day. See if you can nd out how much sterling fell against the DM in the week after it was forced out of the exchange rate system of the European Monetary System in 1992 – Wednesday 16 September. (Hint: try http:// pacic.commerce.ubc.ca/xr/)

5	Why might the increased protection provided to individual traders by the derivatives markets increase the risk of the whole nancial system running into difculties?

6	Why did the US central bank (the Federal Reserve) feel the need to rescue a privately owned and run hedge fund (LTCM) in late 1998? Should public resources be used in this way?

7	How many ways are there of a British investor going short in US dollars or giving itself the opportunity of going short? Why might a British investor wish to go short in US dollars?

8	Why is it more risky to write (sell) options contracts than to buy them?

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	Answers to exercises
Further reading

P Howells and K Bain, The Economics of Money, Banking and Finance. A European Text

(Harlow: Pearson Education, 3e, 2005) chs. 19 and 20

P Williams, ‘The foreign exchange and over-the-counter derivatives markets in the United

Kingdom’, Bank of England Quarterly Bulletin, Winter 2004, 470–84

For stories and latest data on derivatives markets, see the Financial Times website,

http://www.ft.com

Answers to exercises

9.1	(a)6,750 per cent (calculation done on the basis of a 360-day year). (b)Transaction costs, specically commission to the exchange member who arranged the contract and to the clearing house. (c)Day 3: buyer pays $625; Day 4: buyer pays $1,250; Day 5: buyer pays $625.

9.2

(b)Both sets of rates rose steadily – the rates implied by futures prices rose from 4.73 for June 2006 contracts to 5.16 for June 2007 contracts. The interbank sterling rates were also higher for longer periods, varying from 4.53% overnight to 4.953% for one year. In all cases, the interbank sterling interest rates were lower than the rates implied by futures prices. (c)The rates are different in kind. Buyers and sellers of interest rate futures are gambling on changes in the interest rate over the following three, six or twelve months. If the market were fully efcient, the implied rates would indicate what would happen to interest rates in general in the near future. Interbank sterling rates are all current rates for deposits made now of differing periods. That is, interbank interest rates trace out a yield curve. As Chapter 7 explains, a major element in the relationship between shorter and longer-term rates is market expectations about future changes in interest rates, but other factors inuence the shape of the yield curve.

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CHAPTER10