Financial derivatives: types, valuation, and risk management

Derivatives

The line between the increased use of derivatives in corporate risk management and central bank monetary policy is not always clear, but there is a strong case to suggest that traditional monetary policy has either become less effective or has otherwise changed as the result of increased derivatives use. Corporate finance divisions focus on derivatives as a mechanism for managing risk, and the financial community has responded to this increase in demand with a dramatic increase in the derivative products available.

Fender (2000) argues that the increased use of derivatives in corporate finance has a significant impact on monetary policy. Derivatives enable users to separate and repackage market risk. The increased sophistication and availability of derivatives enables corporate finance departments to use those derivatives as hedging mechanisms. The use of interest rate derivatives in particular -- to hedge against rate changes or foreign exchange rate risk -- dilutes the impact of monetary policy on the economy. Gomez, Vasquez and Zea (2005) argue that derivatives both reduce the effectiveness of monetary policy and increase the transmission of policy. The precise nature by which this change in the pace of transmission has yet to be determined, but the leverage that derivatives provide allows firms -- including banks -- to make moves that are faster and more intense in nature than they would be able to do without derivatives. Thus, they can transmit new market information more quickly and with more intensity using modern derivatives markets.

Monetary policy is typically implemented by three main mechanisms -- central bank discount rates, open market transactions and reserve requirements. The discount rates are used to affect the cost of capital -- an increase in rates increases the cost of capital and has a contractionary affect on the economy for example. What Fender argues is that the use of interest rate hedging mechanisms weakens the macroeconomic impact of central bank discount rates as a means to impact the economy -- firms are less affected by changes in the interest rates because they are hedging their interest rate risk. Thus, central bank policy is not as effective today as it was in past eras when financial derivatives were far less commonplace.

This will naturally have an impact on how central banks implement monetary policy. The discount rate has commonly been perhaps the most popular tool in the central bank arsenal. Reserve requirements are not changed frequently, and open market transactions are more difficult to implement than discount rate changes. However, if the impact of discount rate changes is weakened, the central bank must change its method of implementation in one of two ways. The first is that it may make rate changes more intense, or more frequent, than in the past. By moving rates more quickly and in greater amounts, the central bank's use of the discount rate to impact the economy is more intense in nature than would have been the case previously. In addition, the central bank may eschew discount rate changes in favor of other mechanisms, or may incorporate other techniques along with discount rate changes, something the central bank may not have done previously.

Overall, it is reasonable to suggest that in the short-term, monetary policy is not as effective now in an environment characterized by high derivatives use at the corporate level as was the case even fifteen years ago. However, it is possible that the transmission of changes in exchange rates has increased in that time.

2. In their study of the impact of derivatives on Colombian monetary policy, Gomez, Vasquez and Zea (2005) noted that there were strong positive impacts and strong negative impacts both. Derivatives themselves are not inherently bad, but because of their nature they are a more intense financial transaction than a conventional, non-derivative transaction. Derivatives represent the securitization of risk -- the risk of the movement of a stock price, a change in interest rates or a change in foreign exchange rates. Thus, derivatives can both create risk in the markets and eliminate it, depending on how they are used. This essay will explain this dichotomy.

Jobst (2008) explains that securitization is the pooling of risks (assets) with the intent that such pooling eliminates asset-specific risk through diversification. His example comes from sub-prime mortgages, where the asset-specific risk associated with any one mortgage might be high, but the risk associated with a portfolio of mortgages is going to be low. Financial derivatives of this nature still have market risk, however, as explained in modern portfolio theory. Only asset-specific risk is removed through diversification. Thus, if a market moves strongly in one direction and there is overinvestment in that market, the actual degree of risk remains high because the market risk has remained high.

The same principle applies in reverse. On an individual level, firms use derivatives to reduce their exposure to volatile elements of the market. These can be commodities, interest rates or exchange rates. The use of derivatives for this purpose is known as hedging and for a given firm these hedges work because they are directly applied against the volatile element of the firm's business. At the market level, however, the aggregate use of derivatives can be dangerous. In mortgages, the main issue was that market risk still existed and many firms (especially banks) had allowed themselves to become overexposed to this market risk. When the market went south, the banks lost substantial amounts on these investments. Thus, there can be significant risk to the economy if the moves of individual investors with respect to financial derivatives is weighted heavily in any direction. Such a situation -- a down market attracting substantial put activity for example -- causes the derivative market to lack diversification. Because derivatives are typically leveraged, the impact is magnified. Investors are essentially making bets -- there is more money in the derivatives market than can reasonably be supported by the people in the market. The result is not only stronger market movements than is economically viable but a dramatic increase in volatility as well.

It is the potential intensity of market movements that precisely introduces volatility to financial markets, in a way that would not exist without leveraged derivatives. While derivatives can also have the impact of reducing risk, especially at the firm level, and this allows firms to make better use of financial markets thereby improving liquidity, the volatility increase can be dangerous, and perhaps the more significant impact of the two. The nature of derivatives is such that all market movements, both positive and negative, are amplified by the use of derivatives, and this explains the strong dichotomy where in derivatives serve both a strong positive and strong negative function in the markets.

3. Jobst (2008) explains securitization as the process by which assets are grouped together, the theory being that asset-specific risk will be reduced. This theory, however, does not explain why such a process should increase risk in financial markets. This is better explained when considering that there are two types of risk -- asset-specific and systemic. The structure of any securitized product must recognize that there are two types of risk and address that. Specifically in the case of the mortgage backed security crisis, financial markets must also recognize that no product is free from both asset-specific risk and market risk.

Peterson (2007) noted that mortgage securitization had become popular in the 2000s as a means for banks to spread the risk of their mortgages around the financial industry. These mortgages held risk associated with mortgage type and with geography -- by repackaging them, other buyers could acquire this risk and all players in the banking industry could improve the diversification associated with their mortgage risk portfolios. However, the theory fell apart. One of the most important reasons why the theory fell apart was because some of the major risk factors associated with the housing markets were national in scale. Interest rates are set at the national level, and the state of the economy is also national. Additionally, trends in investment flows (particularly into real estate) also proved to be national. As a result, the level of market risk remained high even when the level of asset-specific risk was reduced through the securitization process.