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FROM THE 1970s to the early 1990s, CERTAIN FINANCIAL

SECCTOR DEVELOPMENT TOOK PLACE WHICH


PRECIPITATED THE EMERGENCY OF Financial
Derivatives. THESE FINANCIAL DERIVATIVES AIMED AT
HELPING MANAGERS OF FINANCIAL INSTITUTIONS TO
REDUCE THE RISK OF DOING THEIR BUSINESS.

You are required to discuss this financial development and


write short but precise note on any four of the financial derivatives
that you studied.

To start with, the need and sole contributor to financial sector development revolves
around financial crisis. The term financial crisis is implied broadly to a variety of
situations in which some financial institutions or assets suddenly lose a large part of
their values. Financial crises have been an unfortunate part of the industry since its
beginnings. Bankers and financiers readily admit that in business so large, so global
and so complex, it is naive to think such events can ever be avoided.

A brief look at a number of financial crises over the last 30 years suggests a high degree
of commonality: excessive exuberance, poor regulatory oversight, dodgy accounting,
herd mentalities and, in many cases a sense of infallibility. William Rhodes has been
involved in the industry for more than 50 years and has lived through nearly every
modern-day financial crisis, many of which are detailed in his book, Banker to the
world. As he puts it, there is a common theme of countries and markets wanting to
believe that they are different and that they as not as connected to the rest of the
worlds economy. In his view, many aspects of the Latin American debt crisis of 1982
have been repeated a number of times and there is much from this crisis which we can
apply to what is currently in Europe, Africa and beyond.

Invest. Management- BSc. Banking and Finance - ABUBAKARR JALLOH


Dept. of Economics; Banking and Finance Njala University Page 1
For this term paper, we are going to highlight few with brief narration:

LatAm sovereign debt crisis 1982

This crisis developed when Latin American countries, which had been gorging on
cheap foreign debts for years, suddenly realised they could not repay it. The main
culprits, Mexico, Brazil and Argentina, borrowed money for development and
infrastructure programmes. Their economies were booming, and banks were happy to
provide loans to the point where Latin American debt quadrupled in seven years.
When the worlds economy went into recession 1970s the problem compounded itself.
Interest rate on bond payments rose while Latin America currencies plummeted. The
crisis officially kicked off in august, 1982 when Mexicos finance minister Jesus Silva-
Herzog said the country could not pay its bills. Rhodes recalls it as a tense period, but
says that strong political leadership enable them to get through the crisis. He laments,
however, that the lessons of the crisis werent heeded.

Savings and Loans crisis- 1980s

While the solution to the Latin American crisis was being put together, a domestic one
was happening right in front of the United States regulators. The so-called savings and
loans took place throughout the 1980s and even into the early 1990s when more than
700 savings and loan associations in the US went bust. These institutions were lending
long term at fixed rate using short term money. As interest rate rose, many became
insolvent. But thanks to a steady stream of deregulation under President Ronald
Reagan, many firms were able to use accounting gimmicks to make them appear
solvent. In a sense, many of them resembled Ponzi schemes. The government
regulated with a set of regulations called the Financial Institutions Reform, Recovery
and Enforcement Act of 1989. While the act tightened the rules on S&Ls, it also gave
Freddie Mac and Fannie Mae more responsibility for supporting mortgages for lower-
income individuals.

Stock Market Crash 1987


Invest. Management- BSc. Banking and Finance - ABUBAKARR JALLOH
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Despite the shock of the savings and loan crisis, two more crises took place before the
1989 Act. The most memorable was the 1987 stock market crash. On what became
known as black Monday, global stock markets crashed, including in the US, where the
Dow Jones index lost 508 points or 23% of its value. The causes are still debated. Much
blame has been placed on the growth of programme trading, where computers were
executing a high number of trades in rapid fashion. Many were programmed to sell as
prices dropped, creating something of a self-inflicted crash.

And other crises like: Junk Bond Crash-1989, Tequila Crisis-1994, Asia Crisis-1997/98
and Dotcom Bubble-1999 to 2000 etc.

To crown it all, below are few highlighted types and causes and consequences of
financial crises:

Banking crises ( Bank run and Credit crunch)


Speculative bubbles and crashes (Stock market crash and Bubble/economics)
International crises (Currency crisis, capital flight and sovereign default)
Wider Economic crises (Recession and Depression/economics)

Causes and Consequences:

Strategic complementarities in financial markets


Leverage-borrowing to Finance investments
Asset-liability mismatch
Regulatory failures
Fraud
Contagion/system risk
CEcopathy

See also brief illustration of The Demise of the Golden Age

In the 1970s, the United States position as the unchallenged colossus of the capitalist
world was suddenly threatened from multiple directions: rising international
competition, spiking energy prices, declining productivity and profitability, and soaring

Invest. Management- BSc. Banking and Finance - ABUBAKARR JALLOH


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inflation and unemployment. The United States trade deficit crept up in the course of
1960s, and government deficits emerged late in the decade and persisted through the
1970s. Declining international confidence in the dollar led to the depletion of the U.S.
government gold reserves, as international holders of dollars demanded redemption of
their dollars for gold. (The Nixon administration responded by ending the fixed-rate
convertibility of the dollar for gold.) Inflation picked up in the late 1960s, racketing up
from about 3% in 1966 to nearly 6% in 1971. While these rates may not look that high
now, they were alarming at the time, coming on the hills of a seven year period in which
the annual inflation rate never exceeded 1.6% (Nixon responded to the threat of inflation
with unprecedented peacetime wage and price controls). In 1973-1974, the first of two
major oil shocking increased the price of petroleum four-fold, dramatically raising
energy costs for both consumers and businesses. Workers wage demands outpaced the
rate of productivity growth, driving up unit labour costs for businesses. The annual
inflation rate spiked to over 10% in 1974 and again in each of the three years from 1979 to
1981. The annual unemployment rate topped 8% in 1975 and would reach nearly 10% in
1982.

The shift in policies differed in timing, content, and speed


from country to country and included many reversals.
Broadly:
African countries turned to financial liberalization in the 1990s, often in the context
of stabilization and reform programs supported by the International Monetary Fund
and World Bank, as the costs of financial repression became clear.

In East Asia, the major countries liberalized in the 1980s, though at different times
and to different degrees. For example, Indonesia, which had liberalized capital flows in
1970, liberalized interest rates in 1984, but the Republic of Korea did not liberalize
interest rates formally until 1992. Low inflation generally kept East Asian interest rates
reasonable in real terms, however. In most countries, connected lending within
industrial-financial conglomerates and government pressures on credit allocation
remained important.

Invest. Management- BSc. Banking and Finance - ABUBAKARR JALLOH


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In South Asia, financial repression began in the 1970s with the nationalization of
banks in India (1969) and Pakistan (1974). Interest rates and directed credit controls were
subsequently imposed and tightened, but for much of the 1970s and 1980s real interest
rates remained reasonable.
Liberalization started in the early 1990s with a gradual freeing of interest rates; a
reduction in reserve, liquidity, and directed credit requirements; and liberalization of
equity markets.
In Latin America, episodes of financial liberalization occurred in the 1970s but
financial repression returned, continued, or even increased in the 1980s, with debt
crises, high inflation, government deficits, and the growth of populism (Dornbusch
and Edwards 1991). In the 1990s, substantial financial development occurred, although
the degree and timing varied across countries.

In the transition economies, financial liberalization took place fairly rapidly in the
1990s in the context of the reaction against communism (Bokros, Fleming, and Votava
2001; Sheriff, Borish, and Gross 2003).

The earliest policy changes generally focused on interest rates. In many instances
governments raised interest rates with a stroke of the pen to mobilize more of the
resources needed to finance budget deficits and to enable the private sector to play a
greater role in development. (Some interest rate increases, designed to curb capital
flight, were intended more for stabilization than for liberalization.) New financial
instruments were introduced that had freer rates and were subject to lower directed
credit requirements.

In response to the reduction of such financial crises and risks managers of financial
institutions became more alert to financial innovations by the introduction of new
financial instruments to better control and manage the risks and crises they faced.

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In the last 25 years derivatives have become increasingly important in the world of
finance. Futures and options are now traded actively on many exchanges throughout
the world." (Hull 2006, p. 1)

Mishkin (2006) is even more adamant that derivatives are new financial instruments
that were invented in the 1970s. He suggests that an increase in the volatility of
financial markets created a demand for hedging instruments that were used by
financial institutions to manage risk.

Does he really believe that financial markets were insufficiently volatile to warrant
derivative trading before the 1970s?

Starting in the 1970s and increasingly in the 1980s and 90s, the world became a riskier
place for the financial institutions described in this part of the book. Swings in interest
rates widened, and the bond and stock markets went through some episodes of
increased volatility. As a result of these developments, managers of financial
institutions became more concerned with reducing the risk their institutions faced.
Given the greater demand for risk reduction, the process of financial innovation
described in Chapter 9 came to the rescue by producing new financial instruments
that helped financial institution managers manage risk better. These instruments,
called derivatives, have payoffs that are linked to previously issued securities and are
extremely useful risk reduction tools." (Mishkin, 2006, p. 309)
The widespread ignorance concerning the history of derivatives is explained by a
dearth of research on the history of derivative trading. Even economic historians are
not well informed about the long history of derivative markets. A review of three
leading economic history journals - the Journal of Economic History, the Economic
History Review and the European Review of Economic History - has yielded not a single
article after 1990 with a title that would indicate that it deals with some aspect of the
history of derivative securities. Similarly, the Oxford Encyclopaedia of Economic
History (2003) gives short shrift to derivative markets; it includes an entry on
commodity futures in the United States in the nineteenth century and options are

Invest. Management- BSc. Banking and Finance - ABUBAKARR JALLOH


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shortly mentioned in the entry on the stock market. At the moment, articles on the
history of derivatives can be found only in working papers and edited volumes.
Goetzmann and Rouwenhorst (2005) includes an article by Gelderblom and Jonker on
derivative trading in Amsterdam from 1550 to 1650, and two volumes edited by Poitras
(2006/2007) contain the so far most comprehensive collection of articles and sources
on derivative markets during the past four hundred years.

The history of derivatives has remained unexplored because there are few historical
records of derivative dealings. Derivatives left no paper trail because they are private
agreements that have been traded in over-the-counter markets for most of their
history. Even today, the international commodity and financial markets, which have
always been a primary focus of derivative dealings, remain beyond the reach of
national statistical offices. Another reason why historical records of derivatives are
scant is conceptual. A forward contract has no market value when it is set up,
although its notional value may be large. Thus, how should a forward contract be
recorded when it is set up? There is naturally no point in recording a zero value. This
problem is even more acute with futures contracts whose market value does not
deviate much from zero during their entire life. At the end of each day, the value of a
futures contract is set back to zero by crediting or debiting the daily change in value to
a margin account. The Triennial Central Bank Survey of the Bank for International
Settlements, which was first published in 1989, for the first time addressed the
conceptual and practical difficulties of recording derivative dealings in international
over-the-counter markets.

Summary of Derivative Markets


Derivatives are used generally to cover an asset or security rather than one issued by
business or government to raise capital. It is used to cover any asset that is not a
primary asset. In other words, any financial instrument whose value today or at a
future date is derived entirely from the value of another asset or a group of other
assets. These other assets are called a primary asset, a primitive asset or an underlying
asset. Basic derivatives are Futures, Forwards, Swaps, Options, Structured notes, and

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Real Estates. We can have different variations of these, such as interest rate, future
contract, options on futures, mortgage backed securities, swap options and,
commodity linked bonds. Variations of the basic derivatives cover all sorts of options
contractual arrangements and relate the value of other primitive securities. From the
above, one can conclude that any asset that is not a primary asset such as stocks and
bonds is a derivative asset.
Today, the introduction of these new instruments often referred to as Financial
Derivatives have pay-offs that are linked to securities previously issued.

Financial derivatives
These are financial instruments that are linked to a specific financial instrument or
indicator or commodity, and through which specific financial risks can be traded in
financial markets in their own right. Transactions in financial derivatives should be
treated as separate transactions rather than as integral parts of the value of underlying
transactions to which they may be linked. The value of a financial derivative derives
from the price of an underlying item, such as an asset or index. Unlike debt
instruments, no principal amount is advanced to be repaid and no investment income
accrues. Financial derivatives are used for a number of purposes including risk
management, hedging, arbitrage between markets, and speculation.
The most vital financial instruments that managers of financial institutions normally
used in their various markets to minimize such risk include:
1. Forward contracts
2. Financial options
3. Financial swaps contract
4. Financial future contract

1. FORWARD CONTRACTS:
A forward contract is an unconditional financial contract that represents an obligation
for settlement on a specified date. At the inception of the contract, risk exposures of
equal market value are exchanged. Both parties are potential debtors, but a

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debtor/creditor relationship can be established only after the contract goes into effect.
Thus, at inception, the contract has zero value. However, during the life of a forward
contract, the market value of each partys risk exposure may differ from the zero
market values at the inception of the contract as the price of the underlying item
changes. When this occurs, an asset (creditor) position is created for one party and a
liability (debtor) position for the other. The debtor/creditor relationship may change
both in magnitude and direction over the life of the forward contract. Forward
contract is a non-standardized contract between two parties to buy or sell an asset at a
specified time at an agreed price.

Some Merits of forward contracts are as follows:


The use of forwards provide price protection
They can be matched against the time period of exposure as well as for the cash
size of the exposure.
Forwards are tailor made and can be written for any amount and term.
They can be as flexible as the concerned parties want them to be.
They are easy to understand and are over-the-counter products.

Demerits of Forward Contracts are as follows:


It is subject to default risk
Even where counterparty is found one party may not get as high a price it wants
for lack a willing partner i.e. this market lacks liquidity.
It requires trying up capital. There are no intermediate cash flows before
settlement.
It may be very difficult to find a counterparty to make the contract with even
where brokers exist to facilitate the process.

2. FINANCIAL OPTIONS:

Invest. Management- BSc. Banking and Finance - ABUBAKARR JALLOH


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These are derivatives contracts and another way for hedging interest rates and stock
market risks on financial instruments. Option gives the right but not the obligation to
buy or sell an asset at a set price on or before a given date i.e. call or put options. It is
also a contract in which the writer (seller) promise that the contract buyer has the
right, but not the obligation, to buy or sell a certain security at a certain price (the
strike price) on or before a certain exercise or expiration date. The owner or buyer of
an option doesnt have to exercise the option he or she can let the option expire
without using it. An identification of two types of options is:
a. American Option which can be exercise at any time up to the expiration date of
the contract and,
b. European Options which can be exercise only on the expiration date.

Merits of trading in options:


Options allow you to employ considerable leverage. This is an advantage to
disciplined traders who know how to use leverage
Some strategies like buying options, allows you to have unlimited upside with
limited downside.
Options allow you to create unique strategies to take advantage of different
characteristics of the market like volatility and time decay.
Options allow you to take a position with very low capital requirements.
Someone can do a lot in the options market with $1,000 but not so much in the
stock market.

Demerits of trading in options:


Many individual stock options dont have much volume at all. The fact that
each option able stock will have options trading at different strike prices and
expirations means that the particular option you are trading will be very low
volume unless it is one of the most popular stocks or stock indexes.
Options tend to have higher spreads because of the lack of liquidity. This
means it will cost you more indirect costs when doing an option trade because
you will be giving up the spread when you trade.
Invest. Management- BSc. Banking and Finance - ABUBAKARR JALLOH
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Options are very complicated to beginners. Most beginners, and even some
advanced investors, think they understand them when they dont.
When buying options, you lose the time value of the options as you hold them.
There are no exceptions to this rule.

3. FINANCIAL SWAPS CONTRACT:


With the exclusion of forward, futures and options financial institutions use one other
important financial derivative to manage risk i.e. SWAPS. A swap is a derivative
contract through which two parties exchange financial instruments. These
instruments can be almost anything, but most swaps involve cash flows based on a
notional principal amount that both parties agree to. Also, there are two basic swaps
that exist:
a) Interest Rate Swap: An Interest rate swap (IRS) is a liquid financial derivative
instrument in which two parties agree to exchange interest rate cash flows,
based on a specified amount from a fixed rate or a floating rate (or vice versa)
or from one floating rate to another. Below are some examples of interest rates
swaps:
The type of interest payment ( variable or fixed rate)
The interest rate on the payment being exchange
The time period over which the exchange continued to be paid
b) Currency swap: deals with the exchange of a set of payment in one currency
for a set of payment in another currency.

Advantages of swaps
Parties with informational advantages who to eliminate interest rate risk may
suffer loss of information advantages
It involves a substantial transaction cost when balance sheets are rearranged

Disadvantages of swaps

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They are subject to the same default risks connected with forward contract thus
leading to considerable loss on one side
Swap markets, like forward market may suffer from lack of liquidity

4. FINANCIAL FUTURE CONTRACT S:


Given the default risk and liquidity problems of interest rates forward markets, the
financial futures contract was developed by the Chicago Board of trade in 1975 this
was to solve the problem of hedging against interest rate risks. A futures contract is a
contractual agreement, generally made on the trading floor of a futures exchange to
buy or sell a particular commodity or financial instrument at a pre-determine price in
the future.

Merits/advantages of trading financial futures contract


The commission charges for futures trading are relatively small as compared to
other type of investments.
Futures contract are highly leveraged financial instrument which permit
achieving greater gains using a limited amount of invested funds
It is possible to open short as well as long positions. Position can be reversed
easily
Lead to high liquidity

Disadvantages of trading financial futures contract


Leverage can make trading in future contract highly risky for a particular
strategy
Future contract is a standardised product and written for fixed amount and
terms

Invest. Management- BSc. Banking and Finance - ABUBAKARR JALLOH


Dept. of Economics; Banking and Finance Njala University Page 12
Lower commission costs can encourage a trader to take additional trades and
lead to over trading
It is subject to basis risks which is associated with imperfect hedging using
future

References:
o Financial Derivatives
Prepared by Statistics Department International Monetary Fund (IMF)
o Mishkin Fredrick S. (2000) The Ec0n0mics of money, Banking and Financial
Markets
6th Edition updated.
Addison Wesley, World student services.
o A short history of Derivative Security Markets
By Ernst Juerg Weber
The University of Western Australia
o Google engine

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