Derivatives: Separating the FACTS from the FEARS
Copyright 2000 Barclay Trading Group, LTD.
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In the beginning, there was volatility. Farmers, manufacturers, processors and other commercial interests needed some way to insulate themselves from the havoc that price volatility was wreaking on their businesses. Thus were born the first derivatives.
During the past twenty years, the growth of derivatives activity has been truly dramatic. The creation of exchange-traded futures and options contracts on energy, currencies, stock indexes and global interest rates, coupled with the internationalization of U.S. pension fund assets, resulted in a bull market for traditional derivatives. Never one to miss an opportunity, Wall Street hired the brightest quants available and through securitization and financial engineering, developed a second generation of exotic derivatives that traded off-exchange. Demand for these products mushroomed as well.
Then, as in a classic Greek tragedy where nemesis follows hubris, the financial press began reporting on case after case of institutions losing tens and even hundreds of millions of dollars in derivatives-based transactions. Although in most of the cases the losses clearly resulted from incorrect assessments on the future direction of interest rates, the press-and, as a result, the public-decided that derivatives were to blame.
As a result, U.S. pension funds are shying away from adding new derivatives strategies. According to the January 8, 1996 issue of Pensions ~ Investments, "Pension executives are wary of getting burned and of the negative publicity surrounding derivatives." In addition, numerous state legislatures have introduced proposals to severely limit or ban the use of derivatives by state pension plans and municipalities.
Is this a reasoned response or a rush to judgment? In order to get a better understanding of the issues involved, we've gathered a distinguished panel of experts to evaluate the risks and benefits of derivatives. Our panel includes:
Charles Froland, General Motors Investment Management Corp. Mr. Froland is Managing Director of Fixed Income for GMIMCo. Prior to joining GMIMCo, he was Managing Director of Investments for the Stanford Management Company which is responsible for the financial affairs of Stanford University. He has published several journal articles and was a member of the Board of Editors of the Journal of Portfolio Management.
Donald M. Horwitz, The Woodward Group. Mr. Horwitz is the Managing Director of The Woodward Group, a consulting service providing end users and dealers with expert advice on the management of derivatives risk. He has held legal, regulatory and management positions within the derivatives and financial services industry for more than twenty years. In conjunction with Professor R. Mackay, he has recently authored a study entitled Derivatives: State of the Debate. (A copy of this study is avail able from Barclay.)
Dr. Thomas Schneeweis, University of Massachusetts at Amherst. Dr. Schneeweis is Professor of Finance and also Director of the Center for International Security and Derivative Markets at the School of Management, U.Mass. He has published numerous articles in academic and practitioner financial journals and is on the associate boards of editors of several nation al financial journals.
Matthew R. Smith, Lotsoff Capital Management. Mr. Smith is Portfolio Manager at Lotsoff Capital Management. Prior to joining Lotsoff, he was a Senior Portfolio Manager for the Amoco Corporation Pension Fund. Mr. Smith designed innovative investment strategies using aggressive cash management combined with futures or swaps to achieve value-added performance over benchmark returns. Before joining Amoco, he was a Partner and Senior Asset Allocation Analyst at Brinson Partners, a global money management firm.
Q: Derivatives are utilized by financial institutions and commercial firms to insulate themselves from the effects of market-specific volatility. Many argue, however, that derivatives trading has actually increased volatility in underlying markets. Can you comment?
Froland: As a general matter, derivatives have seemed to be relatively benign with regard to volatility. Except, perhaps, for isolated periods such as around "triple witching hours", derivatives seem not to have added significant or even measurable amounts of additional volatility. The most careful examination of this issue was carried out in the wake of the 1987 crash by the Kirby Commission and by academics such as Sandy Grossman who essentially exonerated futures and derivatives of having responsibility for adding volatility.
"Just because one can trade the Nikkei in Chicago does not mean that the Japanese financial markets are now more closely linked to the U.S. A number of analyses of global trends in the valuation of financial assets suggest that the country effect is undiminished in its effect on asset prices..."
Still, there is much anecdotal evidence which blames derivatives for market breaks, and in short periods this may be borne out by the data. However, as a matter of systematic risk, it is likely that derivatives have not added volatility to the broader markets.
Horwitz: It is clear that derivatives have not increased the volatility in the underlying markets. In our study, Derivatives: State of the Debate, Professor Robert J. Mackay of Virginia Tech and myself reviewed over one hundred articles, speeches and studies about the use of derivatives and deter mined that these instruments do not increase the volatility in the underlying markets. This conclusion has been supported by statements of regulators, end-users and government officials. For example, Representative James Leach stated in 1993, "It is important to acknowledge the benefits that derivatives products provide as a risk management tool both to financial and non-financial firms. The prudent use of derivatives helps market participants guard against market volatility, thus providing a more stable environment for job creation." The 1993 seminal study by the Group of Thirty concluded: "The academic research on the effects of derivatives on market volatility is increasingly consistent in its findings...that derivatives trading either has no effect on or reduces volatility in the underlying markets."
Schneeweis: It is a common misconception that derivatives trading has increased price volatility in the under lying cash markets. This concern has been fueled by articles in the public press as well as discussions in other national media. Several reasons exist for this public misconception.
Firstly, although derivatives have existed for thousands of years, the general public regards derivatives as a new phenomenon. Since most people believe (although incorrectly) that cash markets have witnessed high volatility in recent years, the obvious culprit must be that new kid in town, derivative markets. Secondly, for cash traders, derivative markets have increased the speed by which cash prices react (through the arbitrage process) to new information. This increased "informational efficiency" has led some cash market traders to blame the increased speed of cash market trading on derivative markets.
Lastly, derivative markets may have resulted in increased historical measures of cash price volatility. In the past, individuals would not trade a cash market instrument unless there was a significant change in new information. As a result, the reported price would remain stable. Today, since derivative markets have lowered the transaction costs (e.g., bid/ask spreads) of holding cash positions, individuals trade cash positions even when there is a small change in information. To some, this increase in reported cash market volatility (e.g., more rapid price movements as prices react quickly to new information) is a negative impact of derivatives trading. However, to the extent that this cash price movement reflects real information, derivatives trading helps cash markets better reflect the true market price rather than an outdated price which does not reflect that a purchase or sale would have to be made.
Smith: Anyone who watches markets knows that a large derivatives trade can cause a market to move sharply. However, this is typically a very short-lived phenomenon, lasting from a few minutes to perhaps a day. Nor are derivatives unique in their ability to create volatility. Market participants will jump on any rumor or perceived bit of information in pursuit of profits. Fisher Black called this "noise trading".
There is no empirical evidence that markets today are any more volatile than before derivatives were introduced. Nor is there evidence that markets without derivatives, say some foreign markets, are inherently less volatile than markets with derivatives. Indeed, by allowing risk to be transferred and, thus, for more participants to enter the market who might not otherwise, derivatives should over the longer term reduce volatility.
More participants should also mean that markets are more efficient and therefore serve the valuable purpose of price discovery. Furthermore, options trading and theoretical models provide a way to measure the market's assessment of risk or volatility.
"Derivatives...provide U.S. firms with new and more effective tools to manage their inherent risk exposures, thus reducing the likelihood that these firms will face financial distress and helping to stabilize..."
This would be much more difficult, if not impossible, without the existence of derivatives.
Q: When a "hot" derivatives news story breaks, the financial press occasionally will not differentiate between exchange-traded futures and options and over-the-counter derivatives. How do you view exchange-traded futures and options differently than OTC transactions?
Froland: Exchange-traded derivatives generally have greater integrity than OTC derivatives for the simple reason that they are backed by greater regulation. OTC derivatives are customized in some way, have specific credit risk and are not as liquid (currencies excluded) in comparison to exchange traded derivatives.
Horwitz: Both exchange-traded and OTC transactions are derivatives. Whether an instrument is considered a derivative does not turn on where it is traded. The primary difference between OTC and exchange-traded instruments is the clearinghouse guarantee for exchange-traded instruments. This guarantee significantly eliminates counterparty credit risk. Also, to protect against the risk of default, exchange-traded instruments require some form of collateral or margin. While the use of "credit enhancements" is gaining some acceptance with OTC traders, collateral is generally not required. Additionally, when liquidity is essential, OTC traders lay off their risk on the exchanges.
Schneeweis: Exchange-traded futures and options and OTC transactions are both separate and closely linked. Perhaps a little history on the very establishment of exchange-traded futures and options markets will permit us to focus on the difference. When forward markets were first formed centuries ago, various forms of contract insurance were in existence. For instance, if you reneged on a contract, the king or local prince would enforce the contract in ways not acceptable to today's ethical concepts. More importantly, there was no place to run. When forward contracts were being traded in Chicago in the 19th century, mark-to-market concepts were developed since one could always run and hide (the West was a big place). To this day, exchange-traded contracts are generally regarded as having lower credit risk but a more standardized product. In contrast, OTC products have differing levels of credit risk but a greater ability to form non-standardized products.
Smith: Exchanges, as was once described to me, are wholesalers of blunt instruments. In many cases these work extremely well. For example, Treasury and S&P 500 futures are almost ideal financial tools for hedging broad equity or interest rate risk, but are less efficient at hedging specific industry or corporate bond risk. Exchanges also have the advantage of offering open competitive markets, financial safeguards, and regulatory oversight. The OTC market offers customization, more depth, and regulatory relief. The choice of one over the other depends on the relative importance of these factors to the user.
Q: With all the recent bad news, many have forgotten the advantages of derivatives. What do you see as the major benefits of derivathes for your firm and the U.S. economy?
Froland: The benefits of derivatives primarily fall in the area of risk control. Hedging away unwanted risk is, of course, the usual application which in a larger sense tends to lower the cost of capital to a firm. But derivatives have the more general application of controlling risk in an asset allocation context. The mechanics of rebalancing, of asset allocation exposure and of sculpting specific risk exposures are tasks which are all advantaged by the use of derivatives. More effective control of risk exposures to different markets reduces the strategic leakage associated with a drifting asset mix. At the same time, certain investment structures are more efficiently implemented through derivatives insofar as transaction costs are reduced.
Horwitz: As Professor Mackay and I point out in our study, the recent studies of derivatives have led to a broad consensus that derivatives provide numerous and substantial benefits to end-users and the public at large. For example, derivatives provide a low cost method for end-users to hedge and manage their exposures to interest rates, commodity prices or exchange rates.
"Academics who have studied derivative markets in new economies have all come to a common conclusion that these products result in a closer integration of the relative pricing among instruments that are deliverable into the underlying contract."
Derivatives, for example, provide U.S. firms with new and more effective tools to manage their inherent risk exposures, thus reducing the likelihood that these firms will face financial distress and helping to stabilize employment. In addition, derivatives provide investors and issuers with a wider array of tools for managing risks and raising capital. This ultimately lowers the cost of capital formation and stimulates economic growth. As Edward Crutchfield, Jr., Chairman and Chief Executive of First Union Corporation stated, "These new instruments are more efficient tools and have several significant advantages over the more conventional cash alternatives..."
Schneeweis: Change is difficult for all of us. Individuals forget that as recently as the 1980s various public pension funds were not allowed to invest in equities since regulations regarded them as too risky. As financial markets have evolved to meet new product demands of both public and private institutions, derivatives have become a necessary means by which asset positions are managed. The increased size of the public debt market, growing pension fund requirements and the globalization of financial markets all require a claim form that permits easy reallocation of asset positions without the necessary sale or purchase of individual security positions. Similarly, nonfinancial firms faced with increasingly large inventory positions require the means to reduce the risk of price and volume risk.
Thus, derivative markets provide both financial and nonfinancial firms the chance to think more about product creation and less about the price and volume risks surrounding product creation. This reduced risk of holding large financial and nonfinancial inventory positions results in a lower cost and a greater diversity of products.
I suspect, however, that the major advantage for the U.S. economy is simply due to the fact that the failure to permit innovation in the financial markets, as in the real goods market, would result in a stifling of the creative mind which has led to so many advances in all product areas. The simple fact is that we can never go back or limit financial innovation only to those products that the most unsophisticated investor can understand.
Smith: The risk control inherent in many derivatives allows us to create investment strategies for our clients that permit taking a position but with a predetermined amount of dollars at risk. Thus, for example, we can gain exposure to a market and yet assure our clients that their minimum return will be 0% (i.e. no losses).
The other main feature important to us is that derivatives permit broad market exposure in a single instrument with no up-front cost. For example, an S&P 500 future or swap synthetically creates broad equity exposure without having to transact in 500 securities.
Combining these two features creates so-called "portable alpha" strategies. For example, an S&P 500 index fund can be replicated with money market instruments and S&P 500 futures. By taking suitable amounts of risk, the returns from the money market component can be enhanced. Thus, a different skill set-in this case, cash enhancement-can be used to beat an equity index, without picking a single stock. The potential value added is portable using derivatives. The bench mark or asset class is largely irrelevant. Such innovative alternative approaches to managing portfolios would be impossible without derivatives.
In general, markets and derivatives benefit the global economy by allowing for the transference of risk. A particular investment typically is a bundle of desired and undesired risks. Derivatives are a tool that permit one to unbundle the risks, keep the desired risks, and sell undesired ones. For example, foreign stocks offer attractive diversification possibilities but simultaneously embody currency risk. However, through the use of currency futures or forwards, this risk can be largely mitigated. Alternatively, combining domestic money market instruments with foreign equity index futures implicitly creates the same effect. By creating a vehicle for risk transference, global trade and investment are fostered.
"There is no empirical evidence that markets today are any more volatile than before derivatives were introduced. Nor is there evidence that markets without derivatives...are inherently less volatile than markets
Q: Most, if not all, of the well publicized derivative debacles of the past few years have been attributed to losses caused by adverse market moves against an unhedged position. As a result, many have argued that derivatives expose firms to new market risks. Is this a valid argument?
Froland: Most publicized losses associated with derivatives are in reality the result of the sorts of timeless mistakes of hubris that are an abiding characteristic of investment markets. Not understanding the investment one is making, excessive leverage, making a speculative call on market direction which turns out wrong- these are the sort of culprits that underlie market losses since at least the days of the tulip craze. More often than not, derivatives are simply the messengers of the bad news rather than the originators of the problem.
Horwitz: The primary cause of the losses in the recent derivatives debacles is not the instruments but the traders. If you examine each of these situations, you quickly see that the primary cause for each is a lack of risk management controls. For example, in the Orange County situation, the trader speculated in derivatives with the tacit approval of the taxpayers and county officials who were pleased with the substantial returns. In the Barings Bank fiasco, the cause was an uncontrolled (and out-of-control) rogue trader. In the Gibson Greetings case, the losses were due to management's lack of control over the use of derivatives, as well as fraud on the part of Banker's Trust. Derivatives alone do not expose firms to market risks.
The risks facing derivatives dealers and end-users are no different than the risks of trading any financial instrument. The risks are credit, market, legal and operational. These risks have been around for decades. With derivatives, it becomes increasingly more important for end-users to focus on the proper use of these instruments and to manage their risks.
Schneeweis: This is a difficult question. First of all, unless one knows for what purpose a particular exchange traded instrument or OTC position was taken, as well as all of the associated cash positions, it is difficult to say whether the combined derivative and cash position was purposely unheeded. For instance, if the expected profits of the derivative position were negatively correlated with the overall firm cash flows, one could say that what seems unhedged in one corporate office is really lowering market risk for the firm overall. Even assuming that the combined position was set to establish an unhedged position, there is no reason why a firm would always want a perfect hedge. Perfect hedges result in a risk-free rate of return. For most firms, a managed derivatives position reflects returns due to their special knowledge of the market. Thus banks, who supposedly have information as to interest rate moves, often have unhedged positions that include derivative contracts.
At the same time, it is true that certain treasury offices of corporations as well as financial firms may have taken derivative positions that increased the risk/return trade-off relative to a cash-only position. Moreover, they may have done this intentionally. This action may have resulted in a firm being exposed to new market risks but also to greater expected rates of return. When that return was achieved, no one complained or returned their increased dividend (if one resulted from the gains of that position). If the corporate division lost money, then the decision to let that office trade in the derivative markets was ex post a bad decision. However, absent illegal intent, the decision to let various parts of a corporate or financial firm take open positions is simply part of the firm's strategic decision to let the firm benefit from its assumed special knowledge of its officials. In short, if market risks are increased, it is not the derivatives that led to increased market risks, it is the corporate strategy.
Smith: Poor management is to blame. Most, if not all, of the so-called debacles were caused by poorly designed controls, lack of independent over sight, leverage, and human frailties such as hubris and greed. People have lost and will continue to lose (and earn) vast sums of money, no matter what they invest in. Derivatives don't kill portfolios. People do. Any financial instrument embodies risk and return. Derivatives, by their very definition, do not create "new"
-Charles Froland, GMMICo.
market risks. People may decide to gain or reduce market exposure using derivatives, but whether the use of the instrument is appropriate or not depends upon the goals of the program and if the user is an investor, speculator, or hedger (although the difference between these is not always clear). By hedging away all risk, the risk free rate will be earned. If the objective is to achieve higher than risk-free returns, then some form of risk must be taken. The amount of risk to take is the key decision. How the strategy is implemented, whether in the cash market or through derivatives is secondary.
Q: Derivatives, in general, and options, in particular, have contributed to the global integration of financial markets. This integration coupled with the proliferation of dynamic hedging strategies has led some to voice the concern that derivatives exacerbate rather than dampen shocks to the global financial system. What is your view?
Froland: This is a difficult question to answer inasmuch as what people mean by integration varies substantially. Just because one can trade the Nikkei in Chicago does not mean that the Japanese financial markets are now more closely linked to the U.S. A number of analyses of global trends in the valuation of financial assets suggest that the country effect is undiminished in its effect on asset prices which suggests that markets in different countries still go their own way even while cross-border trades are transacted more easily. What role derivatives have in this process remains murky at the moment. What seems to have become more pronounced in recent years are the waves of liquidity flows which impact asset prices. Yet, both the speed and frequency of such financial market behaviors can be observed in historical periods that are significantly different in technological development. At the margin, the availability of execution efficiencies afforded by derivatives would seem to contribute to a speedier pricing of information by markets, but it's not clear that speed in and of itself exacerbates a trend.
Horwitz: In our research for Derivatives: State of the Debate, we found overwhelming support for the proposition that derivatives do not exacerbate shocks to the global financial market. Indeed, derivatives have reduced greatly the possibilities of these financial collapses and have been praised by regulators all over the world for doing so. As stated by Franklin Edwards, professor at Columbia University, "The notion that an expansion in the use of OTC derivatives has somehow increased systemic risk and that additional regulation is needed to reduce this risk has no obvious factual basis." It is clear from our research in this area that the most significant way to reduce the risks of derivatives is for senior management and the board of directors of end-users to fully understand the risk management process.
Schneeweis: Academics who have studied derivative markets in new economies have all come to a common conclusion that these products result in a closer integration of the relative pricing among instruments that are deliverable into the underlying con tract. This increased pricing and informational efficiency is beneficial to market traders. However, as discussed already above, there is some theoretical as well as empirical evidence that derivative markets have resulted in cash prices moving faster to information whether it is "real"-i.e., reflecting true market information-or merely "noise"-i.e., uninformed individuals trading on a hunch or the like. As a result, many contend that derivative markets may result in a greater level of price fluctuations-especially price decreases-resulting in further price decreases as individuals lower their estimates of the true price as they see cash market prices fall. In addition, equity-based dynamic hedging strategies for which one sells equities (or the derivative equivalent) and buys bonds to protect a floor position, may result in a cascading impact. For some, the stock market crash of 1987 is one example of this impact.
However, while the ease of money transfers has certainly increased the speed of information transfer, the crash of '87 was also due to the failure of long-term market buyers (e.g., pension funds) to enter the market as prices fell below equilibrium values. In fact, the increasing use of derivative markets may result in an increased case of holding large cash positions and thus an increase in the number of long-term investors who trade over various markets. Thus, to the degree that derivative markets increase over all financial market growth and sophistication, they may also increase diversification across markets, reducing the concentration in any one market and thus the impact of informational change in any country.
Smith: Certainly one lesson to be learned from events such as the stock market crash of 1987 is that the assumptions behind option pricing models do not always hold. We would hope that the art of risk management has advanced and matured and that more hedging is done incorporating options, with an eye to the probability of market discontinuities.
This is not to say that crashes will never occur again or that volatile markets are gone. Indeed, in 1994 the bond market essentially crashed, albeit not in a single day. The exact cause of this is not completely under stood, but one likely contributing factor was a large amount of highly leveraged speculation on the direction of interest rates. Again, this is not to lay the fault on the doorstep of derivatives. Markets can crash massively without the help of derivatives. Just ask Mexico.
Copyright 2000 Barclay Trading Group, LTD.