Derivative Markets Essay Example for Free

Derivative Markets Essay Last dozen of years are characterized by rash growth of volumes of national and international markets of derivative finance instruments or derivative markets. By opinion of experts, appearance and development of derivative markets is the most important event of economic life within last twenty five years. In the very name of these instruments – â€Å"derives† lays the fact that they appeared and started to develop on basis of floaters and futures almost for all types of exchange products (starting with oil and gas and ending with soy beans and orange juice), and also for exchange index, percent rates, rate of exchange, etc. Presently new types of derivates appeared: on the basis of sea freight rates (London), cost of microprocessors, permissions for environment pollution (USA), etc. To the first generation of derivates specialists relate futures and stock option plans, which are used at organized markets (exchanges) in form of standardized contracts, and also popular at non-exchange market (market OTC – over-the-counter) (William Falloon pp. 26-28) currency swaps, stock option plans and inter-bank agreements regarding forward rate agreement. From the very beginning the main functions of derivates was to provide distribution of risks among participants of business deal, connected with change of stuff price, rates of exchange, percent rates, stock rates, exchange indexes, etc. Nowadays operations with derivates are still the main way of insurance from different risks and risk management. The first signs at derivative markets became successful issue of currency futures in 1972 at Chicago Mercantile Exchange; the second issue of percentage futures followed in 1975 at Chicago Board of Trade. In the first half of 1980-s rapid growth (Remolona, Eli, M., pp. 28-43) of operations with derivates, followed with appearance of more and more new types of derivates. In 1980 appeared New York Futures Exchange; in 1982 London international Financial Futures and Options; in 1986 – MATIF Marche a terme international de France in Paris; in 1988 Swiss Options and Financial Futures Exchanges, etc. At these and other organized (exchange) markets trade is fulfilled by standard (typical) contracts, which are sold or at exchange auctions (MATIF in France), or with help of automatized information systems (for example, Globex). Final calculations for all deals are made by computational (compensational) palates (George Benston and Shehzad Mian pp. 217-246) The first â€Å"legal† operation of currency swap (exchange of dollar to Swiss francs) was made in August 1981 between American company IBM and International Bank of Reconstruction and Development. Market of percentage swaps appeared in the United States by initiative of company â€Å"Sallie Mae†. The major part of swap operations was executed by leading international banks, which in the beginning were present as mediators between participants of currency swaps. In succeeding years banks became to work as active participants of derivative deals, acting at their own cost and in their own interests.   When in the first half of 1980-s derivative market was developing mainly in the United States, in the second half derivative market started to develop quickly in Europe and Japan. Volume of world market of swap operations increased from 200 milliard dollars in 1985 to 2900 milliard dollars in 1990. Such quick growth was stipulated with legal standardization of contracts, development of information systems and means of communications. According to data of questionnaire which was executed by International Swaps and Derivatives Associations, volume of world derivative market for the beginning of 1993 was 5.4 trillion dollars, including percentage swaps – 3.9 trillion dollars, currency swaps – 860 milliard dollars, cap and floor operations – 577 milliard dollars. By approximate estimation of magazine Swap Monitor, volume of derivative markets was much higher – 7 trillion dollars (at the same date of 1993). In the United States only 6 banks control 90% of derivative markets. In France 80 banks act at the market of currency contracts; at option market – 24 banks. Volume of operations with derivates at exchange and non-exchange markets, which make French credit institutions and which are shown at their balance, in 2.2 times exceeds amount of their balances. By information of International Calculations Bank, already in 1991 volume of OTC market was 4500 milliard dollars. From that time its volume significantly increased. Quick growth of derivative market volume in the beginning of 1990-s is connected with increasing of instability and uncertainty at world financial markets, also influenced by such events as was at Persian Gulf, collapse of USSR, crisis of European system of currency, etc. besides, progress in the field of informational technology, which allowed to process big volumes of information almost immediately and great funds, involved in financial turnover, give grounds to speak about existence of real industry of derivates. As we already spoke about, quick growth of derivative market was accompanied by appearance of new and new their types and kinds; this process developed and continues to develop in legal and non-official market. Financial instruments, which represent different combinations of derivates of the first generation, quickly were added to the first derivate generation (for example, combination of percentage options â€Å"cap/floor†, swaptions – combination of swap and option. In the beginning of 1990-s appeared such exotic instruments as swaps for non-typical indexes, annulated swaps, options for options, etc. One of novelties for Parisian exchange was issue of bons doption, which gives right to the buyer for purchase of actions or debentures by fixed price. During the last four years number of diversities of such warranties increased from 15 to 500, they are in easy access to any investor, even those who doesn’t have big amount of money. Appearance of new types and kinds of derivates is stipulated not only by increasing demands of clients in more perfect means of insurance from risks (Ludger Hentschel and Clifford Smith Jr., pp. 101-126), but also by constant perfection of informational technology and equipment, mechanisms of price formation and models of risk management. At the same time legal standards of regulating operations with derivates were developed and perfected; new forms of standard contracts appeared. Operations with derivates started to be used more frequently not only for insurance from risks and risk management, but for aims of speculation, i.e. receiving profit from them. By opinion of experts, nowadays the following subjects take place at the derivative markets: Industrial companies, which can use operations with derivates to reach such aims as: Decreasing of indebtedness burden at the expense of getting necessary financial means by possible cheap price; Increasing of flexibility in management of financial holdings, not limited by usage of debentures or short-term commercial documents; Perfection of management cash balance and regulation of financial flow, connected with cash inflow and cash spending; Fast receiving of necessary funds by relatively low prices in case unexpected needs in financing take place; Perfection and dynamics of process management by liquid assets of enterprise. Although enterprises, which use all enumerated possibilities of operations with derivates, are quite rare, from now on these operations cannot be ignored by those enterprises, who intend to lead dynamic strategy of management by thief financial resources. Different investment funds, which control investment portfolio, use operations with derivates as flexible means of funds management. Special companies or funds (so-called stockjobbers), which make derivative operations to receive profit, because those operations allow even with small expenses to get big profit, indeed, in condition of favorable circumstances for such stockjobber. In such a way American fund Quantum Fund, which belongs to famous financier George Sores, and which is specialized on currency deals, including derivates as well, since 1969 every year increased its income for 35%; today it exceeds 4 milliard dollars. Totally in the United States there are more than 3 thousand of such funds, which manage approximately by 25 milliard dollars, which are used only for speculative operations. There are 23 similar funds, which are legally registered in France. Individual stockbrokers, which make operations with derivates at their own expense. Activity of those subjects, which in the USA are called â€Å"local† and in France â€Å"negociateurs independants de parquet†, assists in increasing of liquidity financial market. Special companies-organizers of the market, including compensational palates, which control execution of contracts and execute calculations, receiving definite commissions. In such a way in France company MATIF received for each operation of purchase or sale of pressing contract 6.25 francs, what allowed to increase own funds to 800 million francs. In 1993 MATIF worked up 72 million of contracts, whereas at Chicago Mercantile Exchange were sold 179 million of contracts. Banks, working in legal and non-official market, receive the biggest income from derivative operations. Supervision instances controlling bank activities (for example, there is Bank Commission in France) are anxious because of uncontrolled growth of bank derivative operations. Operations with different kinds of options, especially related to such indexes, which change quickly, as shares indexes, prices for non-ferrous metals, raw materials, etc. give the biggest concern. Supervision instances don’t limit usage of derivative operations in order to insure credit and market risks (Sanjiv Ranjan Das pp. 7-23), but at the same time they establish rule of paying capacity, in accordance with which amount of own derivate funds of certain credit enterprise should cover credit (risk of unredeemed credit) and market risks. Other aspects of regulation non-organized markets are not developed enough. In all leading Western countries development of those measures is behind the tempo of growth of OTC market capacity, where calculation (compensational) palates are absent and business deals have long-term character. For organized derivative markets the main problems still are guaranteeing security and control. Compensational palates watch timeliness of final calculations and amount of deposits of their members, which operate at derivative market. These deposits guarantee that they will fulfill their obligations: in case amount of deposit is lower than definite level, it should be filled up immediately. In such a way, at MATIF’s accounts are 20 milliard francs, paid-in by its members as guarantee of calculations. Financiers work to standardize contracts for derivative deals in the international level. In such a way, created in 1985 International Swap and Derivatives Association worked out frame contract for derivative operations, consisting of two parts: in the first part there are obligatory common statements (ways of calculations and their regulation, declarations of the parties, procedures of canceling the contract, etc), and in the second part there are statements, which can be changed by wish of the parties. In June 1993 report of 30 leading specialists for financial operations was published, where they formulated recommendations to banks and other enterprises, which lead operations with derivates or are their final users. By opinion of experts, these enterprises should give acces to that market only for professionals. Many experts point at explosive character of derivative market, because there can appear chain reaction of bankruptcy (domino effect). Non-exchange market is more dangerous in this respect, where the business deals are often concluded â€Å"for the word of honor†. Unexpected collapse of one of the banks can cause chain reaction of bankruptcies of other banks. By words of A. Taylor, president of Royal Bank of Canada, derivates represent bomb of delayed-action, which, once exploded, can completely ruin world financial system. Although derivative deals have a lot of risk and can provoke the crisis, you cannot live without them in the modern financial markets, because they assist in increasing of liquidity and effectiveness of financial markets, decreasing of cost for market transactions (deals). As was written in French magazine â€Å"Expansion†, future experts, probably, will examine derivates as financial novelty, which saved world economical growth from paralysis. Works Cited: George Benston and Shehzad Mian, 1995 Financial Reporting of Derivatives: An Analysis of the Issues, Evaluation of Proposals, and a Suggested Solution, Journal of Financial Engineering, September, pp. 217-246. Sanjiv Ranjan Das, 1995 Credit Risk Derivatives, Journal of Derivatives, Spring, pp. 7-23. William Falloon, 1992 How Appetites are Growing for OTC Equity Derivatives, Futures Magazine, January, pp. 26-28. Ludger Hentschel and Clifford Smith Jr., 1995 Controlling Risks in Derivatives Markets, Journal of Financial Engineering, June, pp. 101-126 Remolona, Eli, M., 1992-3 The Recent Growth of Financial Derivative Markets, Federal Reserve Bank of New York Quarterly Review, Winter, pp. 28-43.