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.

The Dual Nature of Derivatives: Risk Reduction and Risk Creation

Gomez, Vasquez, and Zea (2005) noted, in their study of the impact of derivatives on Colombian monetary policy, that there were both strong positive and strong negative effects. Derivatives themselves are not inherently harmful, but because of their nature they represent a more intense financial transaction than a conventional, non-derivative transaction. Derivatives represent the securitization of risk — the risk of a stock price movement, 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.

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 subprime mortgages, where the asset-specific risk associated with any one mortgage might be high, but the risk associated with a portfolio of mortgages is considerably lower. Financial derivatives of this nature still carry 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 market risk has not been eliminated.

The same principle applies in reverse. At the individual level, firms use derivatives to reduce their exposure to volatile elements of the market — commodities, interest rates, or exchange rates. The use of derivatives for this purpose is known as hedging, and for a given firm these hedges are effective 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 the mortgage market, the central 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 declined sharply, banks suffered substantial losses on these investments. There can therefore be significant risk to the broader economy when individual investors' positions in financial derivatives are weighted heavily in any one direction. Such a situation — a declining 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 concentrated bets, and there is more money in the derivatives market than can reasonably be supported by the underlying assets. The result is not only stronger market movements than are economically justified, but a dramatic increase in volatility as well.

It is precisely this potential intensity of market movements that introduces volatility to financial markets in a way that would not exist without leveraged derivatives. While derivatives can also reduce risk — especially at the firm level — and thereby allow firms to make better use of financial markets and improve liquidity, the increase in volatility is potentially more dangerous and perhaps the more significant of the two effects. The nature of derivatives is such that all market movements, both positive and negative, are amplified, and this explains the strong dichotomy in which derivatives serve both a strongly positive and a strongly negative function in financial markets.

Conclusion

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 during that same period. The broader lesson of derivatives — both as policy-dampening instruments and as amplifiers of systemic risk — is that their effects are deeply context-dependent, beneficial under conditions of genuine diversification and harmful when leverage and concentrated market exposure go unrecognized.

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.