Derivatives & Economic Crises

8/6/2019 Derivatives & Economic Crises

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Financial Innovations A Catalyst OfFinancial Innovations A Catalyst OfFinancial CrisesFinancial Crises

(A Study of Great Depression, Recession 2008 &

Pakistan's Economy)

Faiza NawazM.Phil

Hailey College of Commerce

University of Punjab

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Part IPart I

Financial Innovations

&

Great Depression 1930

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Financial Securities: A Major Source ofFinancial Securities: A Major Source of

CapitalCapital

y Till World War I : Less Financial Innovation

y 1922 Organizations Shifted From Banks To Capital

Market

y Securities Issuance Became A Major Source Of

Capital

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Historical Perspective on the Financial Crises : Ivar Kreuger, the Credit-Rating Agencies, and Two Theories about the Function, andDysfunction, of Markets by Frank Partony


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Attitude of Investors

y More Optimistic

y Investment in Stock Markets--- a Fashion

y Every one wanted to buy--- High demand

y

Greediness to earn a loty Buying on Margin

y Banks have also invested deposits in Stock marketwithout depositors consent

y Presumed that Stock Market Prices will always keepon rising

y Demand for productive & capital formation relatingproducts shrinked

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Advent Of New Complex Financial

Instruments

Participating Debentures

Structured Notes

Offshore Subsidiaries & Off Balance Sheet

Transactions SPV

Non Voting Stock

Participating Preference Shares With

Dividend Debentures With Varying Conversion Rights

& Obligations

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Complexity Facilitating Poor RiskComplexity Facilitating Poor Risk

EvaluationEvaluation

y Complex Financial Methods

yAccountants & Auditors Perform Superficial Examination

y No Legal Obligation Binding Accountants & Auditors To

Additional Responsibility

y Most Of The Companies Dont Issue Financial

Statements; Others Include Only Cursory Information

y Financial Statements : Not A True Picture Of Financial

Position 6


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Worst Night Mare for Over Traded

Investors

y A Financially Sound Company , Including The MoneyOf A Number Of Investors & Creditors ; SuddenlyDeclared Bankrupt

y Sudden Fall in Stock Pricesy Stock Market Crash

y Investors lost money

y Have to payback to brokers the borrowed money

y Banks lost the depositors moneyy A number of Institutions lost their existence

y Unemployment replicated

y Great Depression7


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PART IIPART II

Financial Innovations & Recession 2008

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Causes of Recession 2008 : PilingCauses of Recession 2008 : Piling

UUp of Five Major Bubblesp of Five Major Bubbles

y New Economy ICT Bubble

y Real Estate Bubbley Innovations In Financial Engineering With

Derivatives

y Commodity Bubbley Stock Market Bubble

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Financial Bubbles, Real Estate Bubbles, Derivative Bubbles, and the Financial and Economic CrisisD. Sornette, R. Woodard


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Financial Engineering withFinancial Engineering with

DerivativesDerivatives

Derivative is contract whose value is based onor derived from a traditional security or an

asset.Future

Forward

Swap

Options

Call Option

Put Option

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Types of Derivatives

Derivatives

Credit

Derivatives

f dedDerivatives

Credit

Defa lt

Swaps

(CDS)

Credit

Spread

Optio s

(CSO)

Total Rate

of Ret r

Swaps

(TRS)

First to

Defa lt

Swaps

(FDS)

F ded

Derivatives

Collateralized

Debt Obligatio

(CDO)

Collateralized Bo d

Obligatio (CBO)

Collateralized Loa

Obligatio (CLO)

Credit Li k Notes

(CLN)

Foreig

Excha ge

Derivatives

I terest

Rate

Derivative

Eq ity

Derivatives

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Development of Credit Derivative Markets: Implications on Monetary Policy and Financial Stability of Developing Economies

like India

Anil Kumar


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Financial Instruments That Triggered

Recession 2008

Asset Backed Securities

(ABS)

Mortgage Backed securities

(MBS)

Residential Mortgage

Backed Securities

(RMBS)

Commercial Mortgage

Backed (CMBS)12

Development of Credit Derivative Markets: Implications on Monetary Policy and Financial Stability of Developing

Economies like India by Anil Kumar


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Collateralized Mortgage Obligation

(CMO)

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Collateralized Debt Obligation (CDO)

Asset Sold Principal & Interest

to SPV

Cash Funding

Originating

BankSPV

Senior

Middle

Risky Notes

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Credit Default Swaps (CDS)

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Development of Credit Derivative Markets: Implications on Monetary Policy and Financial Stability of Developing Economies

like India by Anil Kumar


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Outcomes of Using ComplexOutcomes of Using Complex

FFinancial Instrumentsinancial Instrumentsy Violation of Basic Principle of Risk & Return Sharing

y Fed Increased interest rates in 2005-2006

y Adjustable rates on mortgages moved up

y Monthly payments on loans increased

y Borrowers were unable to pay back: defaultedy Demand for homes decrease

y House prices Fall

y Banks defaulted due to CDOs

y Insurance companies defaulted due to CDSy Perpetual Money Machine; stopped working

y Recession 2008.

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PART IIIPART III

Derivatives & Pakistans Economy

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Advent of Derivatives in PakistanAdvent of Derivatives in Pakistan

y Equity Derivative products were

launched in KSE in 2001.

y Still after ten years it is considered as

under developed as compared to India

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Pakistan Equity Derivatives Market by Faiza Naz


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Users of Derivatives in PakistanUsers of Derivatives in Pakistan

(Authorized Derivative Dealers)

y Banks

y DFIs

y Mutual Funds

y Non Banking Financial Institutions

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Types of DerivativesTypes of Derivatives TTraded inraded in

PakistanPakistan

y Foreign Currency Options

y Forward Rate Agreement

y Interest Rate Swaps

y Future Contracts--- Traded on National

Commodity Exchange Limited (NCEL)

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Reasons of Slow development ofReasons of Slow development of

DDerivative Marketerivative Market

y Some institutions like Banks & Mutual

Funds are only allowed to use derivatives

to hedge their existing position in spot

market

y Internal policies prohibitation

y Lack of knowledge & expertise

y Cash margin requirement & uniqueidentification number based margin

collection from brokers22


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Recommendations ForRecommendations For

Promoting Derivatives InPromoting Derivatives In

PakistanPakistan

y Require initiatives by the regulator and the

exchange to create investor awareness

y Inform and educate brokers, dealers, traders,

and market personnel

y Devote more resources to develop the business

processes and technology necessary forderivatives trading.

y Institutions should try to build competent staff

at all levels. 23


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Recommendations ForRecommendations For

Promoting Derivatives InPromoting Derivatives In

PakistanPakistan

y Market development reforms ;state ownedinstitutions like Employee Old Age Benefit Fund

and National Investment Trust should beencouraged to participate in the derivativesmarket. This will help increase liquidity.

y SECP in association with the Karachi Stock

Exchange Board and Members should designsome mandatory study guidelines for traders,fund managers, settlement officers and otherrelated parties.

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ConclusionConclusion

More the transparency, lesser the

complexity & uncertainty, higher the

preference given to productive rather than

speculative activities and better justified

the risk & return sharing ratio: higher &prolonged would be the market stability.

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Thank You

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