Innovation of financial derivatives

By E.P.A. Sisira Kumara

The term financial derivative instrument is generally accepted to mean a financial instrument with a payoff structure determined by the value of an underlying security, commodity, interest rate, or index. According to some notable surveys, over 80% of private sector corporations consider derivatives to be important in implementing their financial policies. Derivatives have also gained wide acceptance among national and local governments and government-sponsored entities.

Derivatives are used to hedge/lower funding costs by borrowers, to efficiently alter the proportions of fixed to floating rate debt, to enhance the yield on assets, to quickly modify the assets payoff structure to correspond to the market view, to avoid taxes and skirt regulations, and perhaps most importantly, to transfer (hedge) market risk.

These new products, derived (hence the name) from conventional stocks, bonds, mortgages, commodities and currencies, enable bankers and corporate treasures to manage risk and fine- tune their portfolios with speed and efficiency.

Derivative specialists in the field speak their own language/jargon. They rattle off details about caps, collars and different swaps. To people unfamiliar with the glossary of derivatives, the market can be confusing. But the underlying principles are quite simple. 

In fact, participants in the market have sometimes compared derivatives to the simplicity of Lego; different pieces can be snapped together to provide what users want. With the continuing development of powerful computer technology and equally powerful mathematical models, specialists construct derivative products in surprising varieties.

Usually derivatives are a part of off-balance sheet activities of a bank’s business. 

They are flexible and efficient techniques to hedge against volatility of market conditions and adjust risk exposures with more precision, greater efficiency and often at a lower cost than was previously possible.

A derivative transaction may be defined as; 

‘A bilateral contract or payments exchanged whose value is derived, as it implies, from the value of an underlying asset or an underlying rate, or index’. ‘Derivatives transactions cover a broad range of ‘underlying’-exchange commodities, equities and indices’. 

As stated above, we can observe that there are different definitions given by different experts in the world financial derivative market. Derivatives fall into two categories. One consists of customised, privately negotiated derivatives, which are known generically as over-the-counter (OTC) derivatives or, even more generically, as swaps. The other category consists of standardised, exchange-traded derivatives, known generically as Futures. In addition, there are various types of products within each of these two categories. 

Derivatives are used to lower funding costs by borrowers and to hedge the risk of financial transactions. Some of the most common derivatives transactions are forward interest rate swaps, currency swaps, equity swaps, options, futures, credit derivatives and commodity derivatives. 

All the derivatives are combinations of one or more of the following: Credit extension contracts, price fixing contracts or price insurance contracts.

The financial derivatives have played a major role in the financial markets in the world. It is classified as a financial weapon of mass destruction, which carries hidden and potentially danger for the economic system. Sir Julian Hodge, the famous Welsh researcher and banker, stated that “at some time in the future financial derivatives could bring the world’s financial system to its knees”.

The impact of derivatives on the world financial market indicate that the power and the capabilities of the derivatives are much higher and remarkable. It is recognisable that when dealing with financial derivatives the market participants should consider the following myths regarding these products.

• Derivatives are new, complex, high-tech, financial products
• Derivatives are purely speculative and highly leveraged instruments
• Financial derivatives are simply the latest risk associated with derivatives. Banking regulators should therefore ban their use by any institution covered by insurance deposits
• Only large multinational corporations and large banks may have a purpose for using derivatives 
• Financial derivatives are simply the latest risk–management fad 
• Derivatives take money out of the productive processes and never put anything back to it.

The innovation of financial derivatives in the Sri Lankan financial market in a positive manner may help to develop the country.

    

(The writer is a Senior Dealer – Money Market, People’s Bank.)