Financial Derivatives

Evolution of Financial Derivatives 1970 +

The market of financial derivatives emerged in 1970 and has since undergone structural transformation and rapid expansion in both volume of activity and variance of instruments. The concept of a derivative is best explained by thinking of it as within a finance taxonomy of many different instruments. The derivative of any instrument is the value that is placed on an asset or external variable.
The institutions that trade financial derivatives are commercial banks, investment banks, hedge funds, and portfolio/private investors. Levinson (199:2005) states that all derivatives can be broken down into two main categories: Futures and Options.
A Futures contract is an agreement to buy a commodity for a fixed price at a set date in the future. The risk of futures contracts is that over the course of the contract the commodity price can be influenced by economic variables and change in accordance with adjustments to interest rates, inflation etc. This creates incentives to default on the contract obligations and thus increases credit risk. (Kolb, 4:1996)
Options are buying (call) or selling (put) a commodity at a certain price in the future until an agreed date whereby buyer/seller then hold the option to hold on to the contract or sell it. Therefore options derivatives are tied to the risk and value associated in holding or selling a contract.

A market for derivatives in futures and options contracts emerged into financial markets in 1970 as the world underwent drastic changes in the global financial architecture, namely the collapse of Bretton Woods and the floating of exchange rates. During this decade there was a sense of global instability, volatility and risk amongst financial markets and thus the perfect conditions for instruments of futures/options to 'commodify risk' (Bryan & Rafferty, 9:2009).
The price of oil in response to floating exchange rates created a 'shock' amongst global markets. The New York Mercantile Exchange [NYMEX] introduced the first oil futures contracts in 1974 and according to Kolb and Overdahl this sparked a massive opening for derivative markets and investors to capitalize on the volatility of the market at the time. Establishing options and futures contracts between producing nations and oil corporations changed the way oil was traditionally traded in the market which then led to the creation of a whole new financial derivative market [Spot Market] to "facilitate the need for risk management and price discovery" (Kolb and Overdahl, 126:2014). Expansion of derivatives in crude oil markets over the last three decades:
1 June, 1988 - 107,579
1 June, 1998 - 254,162
1 June, 2008 – 1,173,458

The 1980's saw the opportunities for profit grew alongside global debt markets struggling with payments in a new floated currency regime; Latin American amongst the worst. Bryan & Rafferty (10:2009) correlate the expansion to developments in computerized trading technologies as innovation became central to calculations of risk, adjusting pricing models, and attaining precision in speculation in order to capitalize on arbitrage. These elements of high frequency trading and speculation with models and technology have been critised by many as the central cause to the 1987 stock market crash and the 2008 GFC (Matthews, 2012).
Another phenomenon at the time was the emergence of neoiberalism as the dominant political and economic thought. Its doctrine led by scholars Friedman and Hayek in advocating for free markets, deregulation and privatization emerged through the USA under the Regan administration and Thatcher in the UK followed suit.

The Glass Steagall Act 1933 was the separation of commercial banks [lending] from investment banks [underwriting] to avoid conflicts of interest (Jackson, 1987). In 1995 TIME magazine published an article on President Bill Clinton's proposition of banking reform that would enable commercial banks to "affiliate" with Wall Street firms, Insurance companies and other financial service providers and underwriting securities. On 12 November 1999 Glass-Steagall was repealed under the President Clinton administration, and in its place came the "Commodity, Futures and Modernisation Act" and the "Gramm-Leach-Bliley Act".
The effect of the GLB virtually dropped all regulatory barriers of operations between commercial and investment banks; creating a new business of banking or what Markham refereed to as 'Financial Supermarkets' and just two years after the GLB was enacted, "Citigroup passed Merrill Lynch as the nation's largest underwriter of stocks and bond options" (Markham, 1101:2010).

Following the GFC of the 2000's and moving forward greater attention is now being paid to financial derivatives and the institutions and markets in which they operate. Other industries in national economies are affected by the speculation and profit race that large banks and risky investors are competing on. The markets in which derivative contracts operate are dependent upon volatility in real markets in society with real workers and wages. The volatility of industries like manufacturing, commodities and agriculture markets can lead to crises if not controlled, or over speculated.

















Reference

ASIC, 2015. 'OTC derivatives reform 2009', Regulatory Resources. 8 April 2015. Viewed, 9 April 2015.
http://asic.gov.au/regulatory-resources/markets/otc-derivatives-reform/

Bryan, D., Martin, R., and Rafferty, M. 2009. 'Financialisation and Marx: giving capital and labour a financial makeover', Review of radical political economics (41:3)

CFTC, 2014. 'Commodity Futures Trading Commission: History', Viewed 10 April 2014.

Jackson, W. 1987. 'Glass Steagall Act: Commercial vs Investment Banking', Economics Division, Congress Research, IB87061. United States. Viewed, 13 April 2015,

Kolb. R, and Overdahl, J.A. 2014. 'Financial derivatives: pricing and risk management', Wiley & Sons publishing. New York.

Kolb, R. 1996. 'Financial Derivatives: Second edition', University of Miami. Blackwell Publishers. Cambridge USA.

Levinson, M. 2005. 'Guide to financial markets: Options and derivative markets', Profile Books.

Markham, J.W. 2010, "The subprime crisis - a test match for the bankers: Glass-Steagall vs. Geamm-Leach-Billey", University of Pennsylvania Journal of Business Law, vol. 12, no. 4, pp. 1081.

Matthews, C. 2012. '25 years later: In the crash of 1987, the seeds of the great recession', TIME Business Magazine. Viewed, 14 April 2015. < http://business.time.com/2012/10/22/25-years-later-in-the-crash-of-1987-the-seeds-of-the-great-recession/>









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Kolb and Overdahl, 126:2014