Effects of Derivatives on Financial Crises

BUSINESS RESEARCH

Batu Cem Ekiz N0405073

TABLE OF CONTENTS
1. Introduction 2. Literature review 3. Objective of the study 4. Scope of the study 5. Research methodology 6. Limitations of study 7. Introduction to derivatives 8. Types of derivatives 9. Benefits and detriments of OTC derivatives 10.Global crisis and derivatives 11.Conclusion 12.Reflection 13.References 14.Appendix

1. INTRODUCTION
From the time that tulip mania rose in Holland and derivatives tools born as a financial tool, many ideas and counter ideas on relation between financial bubbles and derivatives have been propounded in literature. This research aims to seek the drivers of this relation and what exactly leads crises in nature of derivatives.

2. LITERATURE REVIEW
I can calculate the movement of the stars, but not the madness of men".
Isaac Newton

Claims upon five significant examples on bubbles or purported bubbles will be summarized in this section and in 7th chapter, related collected data will be analysed. The history of derivatives goes to the end of the 17th century. Researches states that first established in 1697, in 1730, Shogunate in Japan published a decree that turned the Dojima Rice Market of Osaka into an official exchange (Norman, 2011). Another driver in history that shaped derivatives; tulips moved to Europe by merchants from Ottoman Empire, leaded a tulip bulb mania in Europe which was characterised by forward contracting on tulip bulbs around 1637, starting from Royal Exchange in London. The first approach claimed by Charles Mackay in his book Extraordinary Popular Delusions and the Madness of Crowds. According to Mackay, participants those bought tulip bulbs and derivatives were left holding contracts to purchase tulips at prices now ten times greater than those on the open market or found themselves in possession of bulbs now worth a fraction of the price they had paid. Also Mackay states that many investors were ruined and Dutch commerce suffered a shock after the deflation of bubble, enormous notional values. As the mania increased, prices augmented, until, in 1635, people who invested a fortune of 100,000 florins in the purchase of forty roots, sold them by their weight in perits1, a small weight less than a grain (Mackay, 2008). I believe giving some numbers in order to compare the notional and actual values will be vital to light the way of understanding modern crisis. One single root of the rare species which is called Viceroy equals 2500 florins which is also equals;
Table 1. Equal of a tulip bulb

Item Two lasts of wheat

Value 448

1 A former moneyers' unit of weight equal to 120 droit or {frac1/9600} grain

Four lasts of rye Four fat oxen Eight fat swine Twelve fat sheep Two hogsheads of wine Four tuns2 of beer Two tons of butter A complete bed A suit of clothes A silver drinking cup TOTAL

558 480 240 120 70 32 192 100 80 60 2500

Approaches of Mackay have been criticised for years mostly by defenders of efficient market hypothesis. A counter approach by Garber to Mackays is a claim that bubble was no more than a drinking game. (The important thing is in this claim derivatives being traded by speculators which means in modern terms, Over-The-Counter.) Another one, Anne Goldgar argues that tulip mania case was limited to small group, and all have been told about the period based on contemporary pieces of propaganda and a plagiarism. As Posthumus pointed out, Thompson states that the reason of 99.999% change in tulip bulb index is the legislation on February 24, 1637, that turns futures contracts written after November 30, 1636, into options contracts. This gave someone who purchased a contract the chance to avoid the contract with a payment of only 3.5% of the contract price rather than 100 % of it. Thompson concludes that process of tulip mania is nothing but an illustration of efficient market prices a consequence of environment that mania was just a response to changes in obligations.
Table 2 and Table 3. Tulip Price Index between 1636-1637

2 Any of various units of liquid capacity; especially : one equal to 252 gallons

Date 01/11/1636 10/11/1636 12/11/1636 25/11/1636 01/12/1636 12/12/1636 03/02/1637 05/02/1637

Tulip Price Index 8.9 8.9 10.5 97 108 176 200 178

148 As similar as Garbers counter claims to 09/02/1637 Mackays on tulipomania, Garber finds the 11/02/1637 145 conclusions of Mackay exaggerated in South 01/05/1637 11 Sea Company and Mississippi Company scenarios. Garber states that these scenarios realized in macro scale, as a difference from tulipomania. According to Garber, the purchasers of the last wave of shares took the greatest losses when stock prices fell, while the initial buyers generally gained and considers these scenarios as chain letter rather than bubble. According to Shea, South Sea subscription shares might have been attractive to small, retail investors and served as a mechanism of getting public cheaply into the market. On the other hand, subscription share markets werent being inefficient doesnt mean that rest of the stock market were necessarily efficient and causes of mispricing of fundamental value, if it existed, caused by these parts of the market. Shea states that it should be appreciated that speculation from 1719 to 1720 was a result of the South Sea scheme was a speculation of not only what form and value the Companys assets would eventually take, but was also a speculation about what form its liabilities would eventually have. The Companys directors muddied the waters for speculators with their own (publicly-avowed) attempts to manipulate the market and their more surreptitious (but widely suspected) efforts in private graft. Also Garber agrees that, these vast macroeconomic and financial experiments failed because their managers lacked the complex financial skills.
Table 4. Mississippi Stock Price

So far, in my point of view, tulip mania shows a micro form of an economic bubble relatively to South Sea and Mississippi Companies and all should be considered as bubbles. Yet, failure of the experiments doesnt prove that the investors are totally irrational (since light of the recent researches in behavioural finance (Kahneman), we assume that actor in a market is not a complete homo economicus. Therefore it should be put the phrase of totally). In all cases there is a common significant driver, especially in tulip mania and Mississippi cases, which is regulations of governments and this is even more determinative than the speculation function of a derivative that traded. After almost 300 years, a crisis occurs starting with real estate bubble in USA, not independent from interest rates, regulators, banking system, property and credit derivatives. As a subject of this research, only approaches on the relation between derivatives and crisis of three economists that have anticipated the following crisis will be included in the scope. In contrast to previous examples, recent crises are agreed on that occurred under significant effect of derivatives. According to Robert Shiller, rather than blaming the tools, it is needed new innovations. In his example, just like crashed airplanes when they first invented, real estate and credit derivatives crashed and they needed to be improved in consideration of their lack of homogeneity, real estate derivatives being incomplete and risk management issue of structured swaps where no chance to be detected and measured by participants. Nouriel Roubini clearly states that rather than innovations, whole financial system has to be changed. Because, these are not newly invented tools and the world has been suffering depressions since 19th century. In addition, the reason

is not a function of a sub-prime mortgages, sub-prime financial system itself. According to him system rotted from the inside out. Dean Baker approaches from another point of view and blames regulators; FED had all the tools necessary to combat the bubble, yet chose not to. Baker states, derivatives should be standardised and rather than over the counter, should be executed at an exchange. In conclusion, when we put aside-to return in following sections- the similarities of drivers of tulip mania case and recent crises, in light of the whole summary of approaches on recent crises highlights new invention of tools, regulators and regulations, standardisation, exchange traded derivatives, reforming the whole sub-prime financial system.

3. OBJECTIVE OF THE STUDY

The role of derivatives in recent global crisis is the main objective of the study. This research aims to seek which functions attributed to derivatives tools. Percentage of types and functions of derivatives in total derivatives tools and their relation between the crisis will be defined in order to understand what specifically lies under the crisis. Based on these findings and regulations that have done so far, possible acts and legislations will be suggested. Finally, It is aimed forecasting what derivatives is going to mean both for markets and companies in close future.

4. SCOPE OF THE STUDY

First of all, this research focuses on derivatives tools functions which lead crisis, other functions of them was touched briefly and left out of the detailed scope. In terms of data and analyses collected, other than years between 2006 and 2011 was ignored. Lastly, due to time and word limits rather than deep research on national stock exchanges and derivatives, research focused on worldwide dynamics and analyses.

5. RESEARCH METHODOLOGY
It is aimed to analyse that derivatives cause bubbles by theory testing methodology for each bubble or purported bubbles with deductive approach. Although most of the data collected are numeric, research is a combine of qualitative and quantitative research. Books, reports of forums, reports of corporations and websites were used to collect required data. On the other hand, some databases such as trade repository websites are closed for retail section but accessible for only wholesale investors as normal. Hence, information of the scope and volume of the trade repositories and other OTC exchanges are missing. However, I believe this lack, wont be vital for the research. On the other hand, reliability of historic data of indexes, subscription prices etc. during 17th and 18th century is a significant tackle for researchers.

6. LIMITATIONS OF STUDY
In addition to time limitation, collecting data from publicly available information was another limitation for this research. Moreover, OTC (Over the counter) derivatives as their nature, they are private contracts between parties which makes harder to collect data in order to a deeper research. As previously mentioned, most of the websites are not accessible for non-corporate users. Finally, relating to these limitations, some aspects may not be covered in the research.

7. INTRODUCTION TO DERIVATIVES
There are three main functions of derivatives markets attract participants: hedging, speculating, and arbitraging. However, variants and classifications of derivatives are main drivers of these functions.

7.1. Common variants of derivative contracts

A forward is a contract, made today wherein a buyer agrees to purchase something from the seller at a specified price on a specified future date. A forward agreement can be written on almost any underlying asset types which will be expanded in following sections. A futures is a standardized form of forward agreement, hence executed at an exchange or a forum that brings parties together and guarantees that both parties will fulfil their obligations. Futures are different from forward contracts, mostly due to design of contracts. The delivery and expiration conditions can be clearly stated and some room for last-minute adjustments also can be left. Besides, futures contracts need to be homogeneous to increase liquidity. They can state exactly the delivery and expiration conditions. In addition, futures contracts are always marked to market which may vary the implied cash flows A swap is an agreement between two parties to exchange future cash flows, one of them based on a floating price and other is fixed one. In other saying, concept of swap aims to exchange to a periodic stream of benefits or payments over a period already arranged. An option grants its holder the right without the obligation, to purchase or sell some asset at a fixed price, on or before a set future date. Options used to increase or in contrast, hedge risk exposure and mostly they are executed at an exchange. There are two types of option; firstly, a call option which gives its owner the right of purchasing some underlying asset for a fixed price at a future time and secondly, a put option gives the right to sell an asset for a fixed price at a future date. In conclusion, the difference between forward and option contracts is being no obligation to buy (or sell) under an option contract in contrast to forwards contracts.

7.2. Classification by underlying assets

Interest rate derivatives refer a type of derivatives instrument which give right (obligation) to receive (pay) a notional amount of money at a given interest rate to parties and in general, traded OTC. Foreign exchange derivatives are derivative instruments where underlying assets are currencies and/or exchange rates. Credit derivatives are instruments for separating and transferring the credit risk of the underlying credit, more precisely loan. Equity derivatives refer a type of derivative which its value is partly or completely derived from underlying equity securities. Commodity derivatives are agreements that give chance to investors profit from commodities such as gold, silver, iron, oil or agricultural crops without possessing them. There are also various types such as weather, economic or property derivatives. 7.3.

Benefits and Lacks of OTC Derivatives

The objective of the research focuses on relation between crisis and derivatives which makes questionable their benefits or even whether their existence is good for markets in the end. Before questioning benefits and detriments, it should be highlighted that many types of derivative are known as zero-sum games. Therefore, in theory, every loser brings a winner to the market. Other than well-known benefits such as risk management, price discovery, operational advantages (low transaction costs) and market efficiency, only speculation as a main driver in relation between crisis and derivatives will be detailed in following section. On the other hand, because of its nature OTC derivatives are privately negotiated contracts and only accessible for parties and this leads some detriments such as detection of risk by regulators or assessing the consequences of a default of an actor in market like in Lehmans case. In addition, in case of recession or crisis, an opaque market triggers uncertainty among participants. As a very nature of derivative contracts, counterparties build up rights and obligations and this carries the risk that counterparties may not honour their obligations. Being counterparty credit risk reminds the question how efficient the amount of collateral that should mitigate the risk. In addition to these lacks of derivatives, due to the management of collateral, settlement of cash payments etc. these contracts still need interventions.

8. DERIVATIVES AND CRISES

By the end of 2006, pre-crisis era, according to the percentages by notional amount outstanding and gross market values of OTC derivatives, interest rate contracts on single currency has the highest percentage with $291,582 billion for notional and $4,826 billion for market value. As a measure of leverage function

of speculation, relatively enormous ratio of notional values to gross market values of interest rate contracts and credit default swaps realised as 60.4% and 60.9% respectively; followed by foreign exchange contracts with 31.8% This clearly states that risk carried by interest rate contracts and credit default swaps are higher relatively, on the other hand with its notional and gross value, interest rate contracts have higher impact in case of deflation of the bubble. Table 5. see Appendix In light of these facts, these two types of derivatives require deeper research. Again by the end of 2006, notional value to gross market value ratio of interest rates by reporting dealers, financial institutions and non-financial customers realised as 64.5%, 56.5% and 61% respectively. Same ratio for credit default swaps by reporting dealers, financial institutions, as a financial institution banks and non-financial customers realised as 67%, 56%, 66% and 40%. For both types reporting dealers are carrying the highest amount of risk and non-financial customers carrying the lowest. On the other hand banks ratio is also at high levels. Table 6 and 7. See Appendix As a consequence of these facts a question springs into our minds; the ratio of banks derivatives and their equities. By the end of 2006, five largest scale banks of USA, Jp Morgan, Chase Bank Na, Bank Of America Na, Citibank National Assn, Wachovia Bank National Assn, HSBC Bank USA National Assn have derivative/assets ratio as following; Table 8. See Appendix Jp Morgan 55.4% Bank Of America Na 22.3% Citibank National Assn 24.9% Wachovia Bank National Assn 10.6% HSBC Bank USA National Assn 27.0% This represents in case of 1% of JP Morgan derivatives go bad, more than half of its equity will drown. In consideration of the volatile environment for now and foreseeable future, this doesnt sound unrealistic. Same banks amount of credit derivatives to assets is as following by the end of December; Jp Morgan 3.9% Bank Of America Na 1.2% Citibank National Assn 1.6% Wachovia Bank National Assn 0.6% HSBC Bank USA National Assn 4.9% Another point of view is comparing derivatives market notional value with combined global stock and bond market value around the world. By the June 2007, derivatives market value 4 times larger with 457 trillion than equitybonds combined value. As of June 2007, the global derivatives market amounted to 457 trillion in terms of notional amount outstanding. By this measure, the derivatives market is

more than four times larger than the combined global equity and bond markets measured by market capitalization.

9. CONCLUSION
No different than a tulip, same drivers of leverage pushes notional value of contracts relatively to its actual value. Main drivers can be stated as the lack of regulation of course and financial system itself too. On the other hand, thesis of invention or patching derivatives is questionable. Because, if drivers of tulip mania and house bubble are same, it shows that rather than functions of derivatives, in what regulations or in an exchange or spot market their being traded matters. After speculators being involved in tulip derivatives trade, it started to become a drinking game or a gamble. Analyse of data points out that, credit default swaps and interest rate contracts are speculated in enormous amounts. Also banks are in total crises in terms of debt rates. As a consideration of future position of markets, highly risky interest rate contracts can be the example of a new crisis. In theory it should be considered that derivatives are zero-sum games but in reality, annual U.S income share of the top 1% reached 23.5% as almost same as the percentage of great depression, 1928. The ticking time bomb that is the derivatives market may implode again. Because, at the same time whole world is discovering another face of derivatives which is Greece and Italy (probably others too) have used derivatives to hide the fact of debt. This shows that a regulation on derivatives not only should consider speculators, banks or reporting dealers but also governments. In conclusion, it should be remembered the expression of Warren Buffett: Derivatives are financial weapons of mass destruction. These weapons shouldnt be given those have no licence, or else somebody should inevitably will injured.

10. REFLECTION First of all, decision of which topic will be chosen for research mostly directed by possibility of collecting data on related topics. Therefore, topics switched between different areas of derivatives. My first idea for topic of this research was applying derivatives tools to different sectors for different assets, mostly commodities. I decided researching the possibility of applying working principle of futures to sale principles of a restaurant or a coffee shop. In this scenario, this new type of futures were going to be a standardized meal deals vary on its time, date, customer number that involves and type of meal which have a specified discounted price on a specified future date. Also, similar to futures being executed at an exchange, these futures were going to be executed at a website which is accessible to all restaurants and customers around the world. This website guarantees that both parties will fulfil their obligations by a rating system among participants. Because, lowly rated

customers wont be accepted by businesses in the end. Simply put, if a customer doesnt purchase the deal on specified discounted price for a specified future date, this ends with loose of rights on discounted price and customer pays the normal price. On the other hand, in practice, testing the theory that claims applying working principles of futures on sale principles of businesses is possible, is quite hard and process of collecting data is also goes to a dead end with these time and money limitations. In my point of view, this research should be supported with surveys on customers consumption habits and its drivers, in addition, in terms of behavioural finance, it should also be highlighted the possible reactions of customers to the new pricing system. In light of these facts, I decided to change my topic into a more specific, narrowed one and most important, a topic which is possible to collect data it requires. Secondly, I decided to focus on roles of derivatives in recent global crisis. Although still the topic was deeper than it should be, in consideration of time limitations at least I thought I can collect data easily from recent reports, researches and other rich sources related with recent crisis. Based on my literature review on progress, I realized that relation between derivatives and crisis is not a new area in finance at all. From tulip mania to recent crisis, there has always been a discussion on derivatives. These discussions brought me to the relation between speculation function of derivatives and bubbles. In light of these discussions, finally, I decided testing the theory of derivatives causing financial crises, in other words bubbles by speculation functions of derivatives. At last, I thought that the research still needed to be narrowed and again as a result of my literature review on progress, I decided to focus on OTC derivatives causing financial crises due to the high relation between regulation level and speculation level in a derivative concept. Thus, regulation in derivatives market became more important sub-topic of my research and this helped me to analyse the implementations and forecasting the derivatives market in future. After decision of topic and drawing borders of area going to be researched, in consideration of limitations, I started to think about on methodology. I decided the test the theory that recently asked by everybody. Do derivatives cause crises? In literature review I specifically chose tulip mania, South Sea and Mississippi Companies. These are the shining examples of contradictive finance and I wanted to be challenged by the clashing theories on reasons of first crises of the world. At first, I didnt think that I will find so many similarities between tulip mania and credit crisis or real estate crisis until I finished the literature review. The idea of highlighting what changed in centuries mostly substituted by the

idea of some fundamentals of derivatives hasnt changed and this, affected the testing of the statement. In process of collecting data, most of the electronic databases for exchange were not accessible for non-corporate users and as I previously mentioned as a nature of OTC derivatives, contracts are private between parties which causes collecting data gets harder. But, data of Bank for International Settlements was an exception. It is probably the best source excluding collecting data in field, face to face, for globally researchers. Also for a research or data limited with USA, data of Office of the Comptroller of the Currency is a source which was used during the calculations of USA banks risk measurement analysis. At the end, whole process, from lectures to decision of a topic or collection of data helped me to improve my understanding of derivatives and global crises in addition to how to conduct a business research. If it is needed for self-criticism, structure of the research could be better organized and focused. Although even only one bubble or crisis is deep enough to develop a research, trying to reach all sufferings of markets during history could have caused a superficial research. Yet, I believe that this research is a milestone in my personal understanding of derivatives and crisis and most important, conducting a business research.
References Norman, P, 2011. The Risk Controllers. 1st ed. United Kingdom: John Wiley&Sons Ltd. Mackay, C., 2008. Memoirs of Extraordinary Popular Delusions. [e-book] US: Project Gutenberg. Available through: Project Gutanberg website <http://www.gutenberg.org/files/24518/24518-h/24518-h.htm> [Accessed 5 January 2012]. Garber, P.M., 2010. Tulipmania. Chicago Journals, 97(3), p.537. Thompson, E.A., 2006. The Tulipomania: Fact or Artifact?, Springer Sciene, Shea, S.G., 2005. Understanding financial derivatives during the South Sea Bubble: the case of the South Sea subscription shares. Shiller, R. Property Derivatives for Managing European Real-Estate Risk Shiller, R. Measuring Asset Values for Cash Settlement in Derivative Markets: Hedonic Repeated Measures Indices and Perpetual Futures Derivatives, 2012. Bank for International Settlements. [online] Available at: <http://www.bis.org/statistics/derstats.htm> [Accessed 20 December2010 ].

Quarterly Report on Bank Derivatives Activities. [online] Available at: <http://www.occ.gov/topics/capital-markets/financialmarkets/trading/derivatives/derivatives-quarterly-report.html> [Accessed 23 December2010 ]. Deutsche Borse Group, The Global Derivatives Market

APPENDIX Table 5

Table 6

Table 7

Table 8