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fiscal policy, risks
1. Introduction A derivative is defined by the BIS (1995) as “a contract whose value depends on the price of underlying assets, but which does not require any investment of principal in those assets. As a contract between two counterparts to exchange payments based on underlying prices or yields, any transfer of ownership of the underlying asset and cash flows becomes unnecessary”. This definition is strictly related to the ability of derivatives of replicating financial instruments2. Derivatives can be divided into 5 types of contracts: Swap, Forward, Future, Option and Repo, the last being the forward contract used by the ECB to manage liquidity in the European inter-bank market. For a further definition of contracts, which should although be known by the reader, see Hull (2002). These 5 types of contracts can be combined with each other in order to create a synthetic asset/liability, which suits any kind of need; this extreme flexibility and freedom widely explain the incredible growth of these instruments on world financial markets. In section 2 I will look at some micro-economic results about derivatives; in section 3 the issue of risk is addressed; in section 4 monetary policy results about derivatives are shown, and in section 5 fiscal policy results are shortly presented. In a brief statistical appendix some relevant data are presented. 2. Some micro-economic results about derivatives Derivatives are financial instruments widely used by all economic agents to invest, speculate and hedge in financial market (Hull, 2002). These functions are strictly related with the financial and mathematical definition of instruments and do not consider the economic contents of financial assets.
Luiss Guido Carli University, email@example.com, viale Pola 12, Rome. I am grateful to Prof. Paolo Savona for his precious advises. This survey is part of a research project about derivatives supported by Guido Carli Association. Usual disclaimers apply. 2 See S. Neftci (2000) for maths details.
With regard to the underlying markets. Generally speaking. Nowadays these markets do not pose any particular safety problem most of all after 1987. most of all because there seemed to be a risk loving behaviour (and then an increase in unmonitored moral hazard). 3. Many of the available statistics and analyses look at exchange traded derivatives. the introduction of exchange traded derivative products 1. issues are liquidity. Some central banks have also imposed modified capital ratios for banks and financial institutions to include derivatives. R.g. increases information about the underlying. derivatives (e. Researches and analysis have focused on the properties of derivatives to influence the underlying markets and the new derivative market itself. The exchange-traded derivatives’ markets satisfy all requirements of transparency. the growth of Over The Counter (OTC) derivatives has an exponential pace (see BIS for some aggregate data) and 3 See B. however. liquidity and risk monitoring and are looked at and controlled by the Exchange Trade Authority and the Clearing House (BIS. is consistent with profit-maximisation. J. Conrad (1989). when a crash of exchange traded options gave rise to the control and monitoring activities. A size barrier to the use of OTC derivatives has been underlined by Hogan and Malmquist (1999). A. transparency and risk. does not seem to increase volatility and risks of and on the underlying market. Massa (2002). Firms actively using derivatives show to have different (few) risk exposure than non-using (Hentschel and Kothari. Cohen (1999). Moreover. Peek and Rosengren (1996) cast doubts about the derivatives trading activities of troubled banks. 2003). M. bid-ask spread and the noise component of prices both decrease3. 2. whereas looking at the derivatives markets. Minton and Moser. the influence on volatility and information asymmetry are of central importance. 2 . and banks using interest rates derivatives experienced a greater growth in their commercial and industrial loan portfolios than non-using (Brewer. 2000). 1995). we can shortly sum up results about markets and instruments widely accepted in the literature. Violi (2000) and many others on the Journal of Derivatives. 2001). price discovery effect improves. which. on the contrary. Craig et al. options) are excellent substitutes of complex investment strategies at a lower cost (Haugh and Lo. 2001) thus completing markets for investors.We will focus on economic functions of derivatives in the following parts of this research project (Savona. The BIS and IMF set out the rules for safe and sound markets structure. 4. From a micro-economic point of view. (1995).
given the impossibility to quantify and control the risks related4. c. The option notional value is not a proxy of the exposure. They tend to create new investment opportunities in order to hedge against any type of risk or speculate (currency. Future contracts increase market efficiency (by lowering trading costs and information asymmetry) and liquidity (given all expiration dates and daily setting of margins). but periodical payments. both for exchange traded derivatives. in absence of any patent protection. They showed to have almost the same properties of futures. whereas option do not give unique empirical results. is somehow solved using codes of conduct and self-regulation 4 P. hearth-quake. underlying markets and OTC. Option contracts have the same effects of futures on markets. and satisfy the need of a single client of the bank (a firm or financial institution). b. Barrieu and N. Notional value of future contract does not represent the exposure of the two counterparts. but no certain data about exchanges and risks are given. Swaps are generally OTC contracts with a longer duration than futures and options. The continuous creation of different types of derivatives by financial institution. credit default. as long as they settle their position each day through margins. and so on). Futures are widely used to hedge and speculate. Forwards are OTC future contracts. not standardised and created on the client needs. but the premium paid to open/close the position represents resources invested. Transparency depends on the international and national laws and is generally very high. confirms that the return on this investment is high for the “creator” of the innovation. where derivatives on earth-quake and other catastrophic events are traded. from a utility maximisation point of view. because futures tend to lower underlying asset’s volatility. both on financial and commodity markets. but not to their financial function. The only drawback can be the unclear effect on volatility of the underlying. e. interest rate. 3 . El-Karoui (2002) look at illiquid markets. they are used to finance liquidity and not to speculate or hedge. In these contracts the notional value of the contract do not represent the risk taken by the two (or more) counterparts. d. and pays back the R&Ds expenditures too (Herrera and Schroth. The legal risk related with the absence in some countries of a strong market regulation. so that the inclusion of them is given only to their structure of time operations.might pose some systemic problems. Micro-economic results about derivatives can be summed up also looking at the single instrument: a. 2002). Repos are time financing operations between the ECB and the European inter-bank system.
R. have been partially adjusted with derivatives in order to let them emerge in the balance sheets of banks and financial institutions.1) Liquidity of derivatives and underlying markets has increased according to the wide use of these instruments by firms. and can exacerbate the effects of shocks for traders. 7 V. Ft+n = St(er(t+n)) (3. in the presence of shocks. the second is not affected by portfolio diversification and is a characteristic of the market and country5. risks related with international exchange traded derivatives is settled by the BIS regulations.C. Edwards (1995). given constant risk free interest rate. M. given the absence of exogenous shocks. Capital ratios and regulation. whereas risks related with OTC derivatives is settled basically by codes of conduct and self-regulation6. 5 6 See W. 4 .agreements. Kroszner (1999). Darby (1994) and F. financial institutions and banks (see Statistical Appendix). The introduction of derivatives might affect the risk of financial markets: from a macroeconomic point of view risk can be divided in systemic and not systemic.R. This is sustainable as long as a monetary authority acts as a lender of last resort for the entire financial system. Systemic risk can be lowered by portfolio diversification and derivatives play a central role in this process. Bhasin (1996). but the general lack of data about OTC instruments might limit our ability to get to a unique conclusion7. brokers and markets as a whole. The first can be diversified and thus lowered. Derivatives and risks The introduction of derivatives by completing information of markets on prices of the underlying on the expiring date of the contract satisfies the price discovery property. The role of international institutions in quantifying the phenomenon is of central importance in our analysis.R. Marshall (1999) for a broader definition of systemic risk. The Balance of Payments has an enter in the Financial Account with the sum of all margins of international derivatives in order to give a rough idea of trading on these instruments. Some central banks impose further (in or off-balance) information on banks and financial institutions about derivatives’ investments. they behave like other financial instruments. 3. Hunter and D. that is the expiring date derivative price can be approximated with the capitalised today spot price.S. facing the Basle Capital Accords. From a macro-prudential point of view. BIS (1996).
Hunter and Marshall (1999) and Hunter and Smith (2002) underline the important relationship between systemic risk and derivatives. although cash can be substituted by daily rolled-over derivatives. 5 . who affirm “derivatives trading may increase informational efficiency of financial markets and provide instruments for more effective risk management”. given that the presence of systemic risk needs the central bank to act as a liquidity supplier for financial markets. Jr Smith (1997). Latter (2001) and M. either on the information side or the money side.Donmez and Yilmaz (1999) state that “a mature derivatives market on an organised exchange leads to a better risk management and better allocation of resources in the economy”. W. An important policy function of the monetary authority is the lender of last resort. 4. The money channel is the principal mean to influence markets and their liquidity. 1997). T. Massa (1994). In the current literature. Financial innovation influences the structure and behaviour of the central banker. Angeloni and M.J. Macro-economic results about derivatives: monetary policy With the introduction of derivatives.A. confirming that the money channel is the first instrument of modern monetary policy. in presence of exogenous shocks. the surprise effect is no longer a way to influence markets because of the impossibility to counterbalance their huge liquidity (von Hagen and Fender. In the following section I will discuss about some key elements of monetary policy. and the process of development of financial markets goes together with the process of changing of monetary theory and policy8. Hooyman (1993). Credit can be substituted by derivatives. they tend to exacerbate the effects. Banca d’Italia (1995a and b). Pawley (1993). there seems to be no clear evidence about an increase of risk.E. L. markets are more perfect thus influencing monetary policy actions (Vrolijk. The classical channels of modern monetary policy are credit and bank (money) (given the impossibility of financing the Treasury in most countries and the existence of floating exchange rates). 1998). strictly related with this issue. according to their different risk propensity. as shown by Fender (2000) and Gorton and Rosen (1995). C. The Long Term Capital Management’s failure in 1998 posed a 8 See I. with derivatives it gradually looses its importance. The credit channel relies its power on market imperfections. in the absence of shocks. The ECB uses Repos as the mean to finance the European banking system with 15 days duration. This is confirmed also by Hunter and Marshall (1999). either systemic or non-systemic. Goodhart (1995). Deutsche Bundesbank (1994). Hentschel and C. C.
P. 2003). Estrella and F. but in its concrete management.S. Glennon and J. A part of the recent literature has analysed the impact of financial innovation on the demand for money parameters. and has come up with some interesting points to focus on9. Biefang-Frisacho et al. there seems to be no certain evidence about the real danger coming from derivatives markets. by increasing the costs of investing and moving capital abroad.g. making money aggregates less meaningful10. but only change the type. Sriram (1999). saying that -given no consensus about the model of systemic risk. transaction and investment costs. which do not include innovation. The degree of substitution with traditional and new investments increases. Tinsley (1998). The introduction of derivatives in emerging capital markets increases international substitutability. However. Tesobono swap in Mexico). Morales (2001) says that derivatives tend to incorporate news faster than the spot markets. like in Switzerland.the role of derivatives on financial markets is not disruptive. 9 See M. thus contributing to increase the possibilities for portfolio diversification.I. thus making the traditional demand for money function unstable in its parameters. posed safety and liquidity problems to monetary authorities acting to the detriment of the liquidity of the monetary and financial system. With derivatives the lender of last resort function is not changed in its scope. most of all in the absence of a liquid primary market. Donmez and Yilmaz (1999) analysed many dramatic incidents involving derivatives markets concluding. Lane (1996).S. attracting foreign investors (e. Ireland (1995) and S. 6 . We treat this property in a Tobin’s framework (Savona. (1994). the substitutability between financial assets and liabilities increases. Rossetti (1998). Looking at emerging markets. Given more perfect financial market. derivatives tend to make the conduct of monetary policy more difficult. Financial innovation might influence the degree of substitution between financial assets in the portfolio of economic agents. Other important failures. The introduction of derivatives on world markets decreases asymmetries. which had to intervene as a counterpart to avoid a credit crunch. 10 See A. like Enron. “they do not seem to create new risks. Central banks in certain circumstance use derivatives as a substitute of the channels of monetary policy. Hunter and Marshall (1999) and Hunter and Smith (2002) confirm this intuition. since they increase the efficiency of markets. moreover. MetallGesellSchaft and Barings. just to mention the most famous.liquidity problem to the Federal Reserve System. Mishkin (1997). structure and nature of the existing”. and others explain which are the advantages for central banks in using derivatives to manage the exchange and interest rates. and that the introduction of restrictions on emerging financial markets increases risk. D. and to complicate the regulatory process.
The 3 coefficients are lower than 20 years ago12. Makar and S. modified to include financial innovation. using the analytic definition of the money base (Fratianni and Savona. but capital ratios of banks. S. β is the compulsory reserve coefficient. 12 See M.P.D. Savona. and γ is the liquidity propensity of banks. it behaves like money base and then is part of the base of the multiplication process of money and deposits11.The definition of money base used by monetary authority influences directly the composition of money aggregates. 1972) and given the econometric results on derivatives and their property of reacting with interest rates. The coefficient β is set at a low level in many developed countries (2% in Europe). Toft (2002). 13 See G. should act as built in stabiliser in the international financial system. by using financial innovation and daily rolled-over investment strategies. the inclusion of derivatives into money aggregates should be straightforward. and the multiplier tends to increase and becomes unstable because there seems to be no built in stabiliser. D. 11 If the reaction has a positive sign.B. The instability of the deposit and money multiplier experienced in the last years in developed countries can be explained by looking at the simple deposit multiplier coefficients: DEP = 1 á +â + ã (4.1) Where α is the liquidity propensity of the private sector (firms and households). like derivatives. and firms manage to minimise cash in order to lower its costs. the coefficient α in a mature financial system is quite low given that households tend to use electronic money.W. Huffman (2001). the coefficient γ is low because cash is a costly asset for banks and they manage to substitute it with daily rolled-over financial instruments. Maccario and Oldani (2000) and Oldani (2002) have tested this reaction property and concluded that for certain instruments the inclusion into the aggregates should be meaningful. 7 . the instrument is considered as money (and not money base). Savona and Maccario (1998). The analytic definition of money base states that if the supply of a financial instrument has a negative reaction on interest rate. Glennon and J. Brown and K. Pawley (1993). Lane (1996). Firms are still out of control in this mechanism13.
It seems to be a debt management strategy coherent with the need to lower the burden of public debt on European economies in the next future. The tax-saving effect is an important incentive to invest in derivatives markets. data about this trading/hedging activity are not available and the study of Piga (2000) on the use of swaps by some Government is the only available at the moment. but a behavioural analysis is still needed. and the books series on this topic by Wiley and Sons is a very useful tool for practitioners and individual investors. Conclusions Derivatives are the widest financial innovation of the last 30 years and their impact on financial markets and operators. investment strategies and risk management. financial literature has developed some mathematical tools for analysing effects of financial innovation. Macro-economic results about derivatives: fiscal policy Studies about the relationship between derivatives and the fiscal policy can be divided into two main categories: the first analysing the impact of using derivatives to lower the cost of debt. Monetary and fiscal policy lack some deep and complete treatment. the problem of derivatives being off-balance sheet items poses many barriers to a complete analysis of fiscal effects for all economic agents. 2002. There seems to be no direct effect on risk. 8 . money and fiscal policy are very important theme to look at for economists. and the second looking at the tax rules about derivatives for investors and at tax savings. which should look at financial innovation as a way to change traditional management of risks and effects. Here a short survey of the recent literature about derivatives and their effect is briefly presented and some interesting underdeveloped areas of the analysis are discussed. 6. The advantages of using derivatives for tax savings are difficult to describe in general. The use of derivatives by the Government (or a Public Agency) to manage debt and lower its cost is a very important field of study. The tax saving is greater for hedging. which is a very important policy issue related with public debt management and credibility. In general. and then firms and banks might tend to declared losses and gains in this form rather than speculation (Hull. especially in Europe. although at an aggregate level (market or institution). His conclusion are quite encouraging. With regard to banks and firms.5. Unfortunately. many countries try to treat differently derivatives’ losses/gains if they come from hedging or speculation. Breuer (2000) has measured off-balance sheet leverage for financial institutions in order to give complete information about risks’ exposure and capital adequacy. 2000 and Anson. Wong. because the use of derivatives (especially swaps) decreases the cost of the debt service and lowers the need for further debt rollover. 2002).
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6 211. 2000 dec.7 37.6 341.8 7924.4 1522.9 16142 30.5 1225.8 74.8 36.4 14125.7 5906.3 240.5 4734.9 2160. 8305.1 17929.8 10687.6 323.5 3734.6 3118.5 7907.2 21.4 377.6 79.4 2444.7 10326.9 1757.7 344.2 3553.8 1502.8 1894.9 3884.4 35.1 3377.9 103.6 67.3 4283 2322.8 27. 2002 sept.9 5918.3 Source: BIS Quarterly Review.2 10292. December 2002 14 .3 2379.5 9265.9 1240.STATISTICAL APPENDIX Tab.3 9672.6 30.4 1162. 2001 dec.4 1605.1 11605.3 1644.6 94.8 37. 1 – Derivatives Financial Instruments Traded on Organised Exchanges by Instruments and Location (Notional principals in billions of US dollars) Instruments/Location FUTURES All Markets Interest rat Currency Equity index North America Europe Asia and the Pacific Other Markets OPTIONS All markets Interest rat Currency Equity index North America Europe Asia and the Pacific Other Markets Amounts Outstanding 1999 dec.2 28.7 8359.5 22.5 12492.8 250.9 6216.9 5299.3 6249.8 80.9 3755.3 65.
9 107679.8 148547.8 10168.9 40584.6 10545.5 33240.7 38973.9 46139 Interest rat 47378.2 3845.8 53574.6 Interest rat 292204.4 9500.3 124.7 69656.2 7408.7 1109.4 1800.2 33408.7 2538.7 30418.4 162 74375.7 10210.2 6622. 2 – Derivatives Financial Instruments Traded on Organised Exchanges by Instruments and Location (Notional principals in billions of US dollars) Instruments/ Location 2000 Year 2001 Year Turnover 2001 Q4 2002 Q1 2002 Q2 2002 Q3 FUTURES All Markets 318201.3 Pacific Other 590 678.5 102.2 116679.5 Equity index 18869.9 191.9 71750.1 33655.4 154490 40516.1 633.4 42851.3 675.3 420934.8 4504.9 34912.8 7836.9 America Europe 111591.6 North 43999.9 38722 Currency 211.1 Equity index 23580.3 689.6 138910.8 355.2 43369. December 2002 119053.3 130868.6 123990.9 65119.3 36134.9 122765.1 25426 7319.8 6533.9 104 9949.5 5839.4 Pacific Other 3253.9 22924.4 45047.Tab.2 4192.8 446358 117647.2 North 150916.8 Markets OPTIONS All markets 66459.3 Currency 2416.3 577.3 Asia and the 4165.3 15 .2 923.9 97.8 8788.9 35136.8 Markets Source: BIS Quarterly Review.9 43520.2 111133.1 667.3 112417.5 243993.8 7631.9 11927.9 133.6 America Europe 17704.5 Asia and the 52440.4 6059.8 2499.5 51939.3 3035 180.7 9217.5 14112.
2002 June Gross Market Values 2000 June 2572 578 1230 293 80 392 937 2000 Dec. 3 – Amounts Outstanding of Over-The-Counter (OTC) Derivatives by Risk Category and Instrument (in billions of US dollars) Risk Category/ Instrument 2000 June Total Contracts Foreign Exchange Interest rate Equity linked Commodity Notional Amounts 2000 Dec. 2001 June 2001 dec. 3183 849 1426 289 133 485 1080 2001 June 3045 773 1573 199 83 417 1019 2001 2002 dec.Tab. June 3788 4450 779 1052 94008 95199 99755 111115 127564 15494 15666 16910 64125 64668 67465 1645 584 1891 662 1884 590 16748 77513 1881 598 14375 18075 89995 2214 777 16503 - 2210 2468 205 75 519 243 78 609 Other 12159 12313 12906 Gross Credit Exposure 1171 1316 Source: BIS Quarterly Review. December 2002 16 .
2001 June 2001 dec. 2002 June 578 849 773 779 1052 283 469 395 314 63 374 335 70 615 340 97 Currency Swaps 239 313 Options 55 67 Source: BIS Quarterly Review. 2002 June 15494 15666 16910 16748 18075 10504 2605 2385 10134 3194 2338 10582 3832 2496 10336 3942 2470 10427 4220 3427 Gross Market Values 2000 June 2000 Dec. December 2002 17 .Tab. 4 .Amounts Outstanding of OTC Foreign Exchange Derivatives by Instrument and Counterpart (in billions of US dollars) Risk Category/ Instrument Total Contracts Outright Forward and Foreign Exchange Swaps Currency Swaps Options Risk Category/ Instrument Total Contracts Outright Forward and Foreign Exchange Swaps Notional Amounts 2000 June 2000 Dec. 2001 June 2001 dec.
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