Derivatives, Risk Management, and Monetary Policy Effects

Derivatives and the Erosion of Monetary Policy Effectiveness

The line between the increased use of financial 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 a 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 expansion 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 them 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 speed of its transmission. The precise nature of this change in transmission pace has yet to be fully determined, but the leverage that derivatives provide allows firms — including banks — to make moves that are faster and more intense than would be possible without derivatives. Thus, they can transmit new market information more quickly and with greater intensity using modern derivatives markets.

Monetary policy is typically implemented through three main mechanisms: central bank discount rates, open market transactions, and reserve requirements. Discount rates are used to affect the cost of capital — an increase in rates raises the cost of capital and has a contractionary effect 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 of influencing the economy. Firms are less affected by changes in 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 adapt its approach 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 becomes more aggressive than would previously have been necessary. In addition, the central bank may move away from discount rate changes in favor of other mechanisms, or may incorporate additional techniques alongside rate changes — something the central bank might not have done in earlier eras.

References

Fender, I. (2000). Corporate hedging: The impact of financial derivatives on the broad credit channel of monetary policy. BIS Working Papers No. 94.

Gomez, E., Vasquez, D., & Zea, C. (2005). Derivative markets' impact on Colombian monetary policy. Banco de la República.