Financial Markets and Institutions (2-downloads)

Lessons from the Subprime Financial

Crisis: When Are Financial Derivatives

Likely to Be a Worldwide Time Bomb?

Although financial derivatives can be useful in hedging risk, the AIG blowup discussed

in Chapter 8 illustrates that they can pose a real danger to the financial system.

Indeed, Warren Buffet warned about the dangers of financial derivatives by charac-

terizing them as “financial weapons of mass destruction.” Particularly scary are the

notional amounts of derivatives contracts—more than $500 trillion worldwide. What

does the recent subprime financial crisis tell us about when financial derivatives

are likely to be a time bomb that could bring down the world financial system?

There are two major concerns about financial derivatives. The first is that finan-

cial derivatives allow financial institutions to increase their leverage; that is, these

institutions can in effect hold an amount of the underlying asset that is many times

greater than the amount of money they have had to put up. Increasing their lever-

age enables them to take huge bets, which if they are wrong can bring down the insti-

tution. This is exactly what AIG did, to its great regret, when it plunged into the credit

default swap market. Even more of a problem was that AIG’s speculation in the credit

default swap (CDS) market had the potential to bring down the whole financial sys-

tem. An important lesson from the subprime financial crisis is that having one player

take huge positions in a derivatives market is highly dangerous.

A second concern is that banks have holdings of huge notional amounts of finan-

cial derivatives, particularly interest-rate and currency swaps, that greatly exceed

the amount of bank capital, and so these derivatives expose the banks to serious risk

of failure. Banks are indeed major players in the financial derivatives markets, par-

ticularly in the interest-rate and currency swaps market, where our earlier analy-

sis has shown that they are the natural market-makers because they can act as

intermediaries between two counterparties who would not make the swap without

their involvement. However, looking at the notional amount of interest-rate and cur-

rency swaps at banks gives a very misleading picture of their risk exposure. Because

banks act as intermediaries in the swap markets, they are typically exposed only

to credit risk—a default by one of their counterparties. Furthermore, these swaps,

unlike loans, do not involve payments of the notional amount but rather the much

smaller payments that are based on the notional amounts. For example, in the case

of a 7% interest rate, the payment is only $70,000 for a $1 million swap. Estimates

of the credit exposure from swap contracts indicate that they are on the order of

only 1% of the notional value of the contracts and that credit exposure at banks from

derivatives is generally less than a quarter of their total credit exposure from loans.

Banks’ credit exposures from their derivative positions are thus not out of line with

other credit exposures they face. Furthermore, an analysis by the GAO indicated

that actual credit losses incurred by banks in their derivatives contracts have been

very small, on the order of 0.2% of their gross credit exposure. Indeed, during the

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Chapter 24 Hedging with Financial Derivatives

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recent subprime financial crisis, in which the financial system was put under great

stress, derivatives exposure at banks has not been a serious problem.

The conclusion is that recent events indicate that financial derivatives pose

serious dangers to the financial system, but some of these dangers have been over-

played. The biggest danger occurs in trading activities of financial institutions, and

this is particularly true for credit derivatives, as was illustrated by AIG’s activities

in the CDS market. As discussed in Chapter 18, regulators have been paying increased

attention to this danger and are continuing to develop new disclosure requirements

and regulatory guidelines for how derivatives trading should be done. Of particular

concern is the need for financial institutions to disclose their exposure in deriva-

tives contracts, so that regulators can make sure that a large institution is not play-

ing too large a role in these markets and does not have too large an exposure to

derivatives relative to its capital, as was the case for AIG. Another concern is that

derivatives, particularly credit derivatives, need to have a better clearing mechanism

so that the failure of one institution does not bring down many others whose net

derivatives positions are small, even though they have many offsetting positions.

Better clearing could be achieved either by having these derivatives traded in an orga-

nized exchange like a futures market, or by having one clearing organization net

out trades. Regulators such as the Federal Reserve Bank of New York have been

active in making proposals along these lines.

The credit risk exposure posed by interest-rate derivatives, by contrast, seems

to be manageable with standard methods of dealing with credit risk, both by man-

agers of financial institutions and the institutions’ regulators.

New regulations for derivatives markets are sure to come in the wake of the

subprime financial crisis. The industry has also had a wake up call as to where the

dangers in derivatives products might lie. There is now the hope that the time bomb

arising from derivatives can be defused with the appropriate effort on the part of

the markets and regulators.

S U M M A R Y

1. Interest-rate forward contracts, which are agree-

ments to sell a debt instrument at a future (forward)

point in time, can be used to hedge interest-rate risk.

The advantage of forward contracts is that they are

flexible, but the disadvantages are that they are sub-

ject to default risk and their market is illiquid.

2. A financial futures contract is similar to an interest-

rate forward contract in that it specifies that a debt

instrument must be delivered by one party to another

on a stated future date. However, it has advantages

over a forward contract in that it is not subject to

default risk and is more liquid. Forward and futures

contracts can be used by financial institutions to

hedge against (protect) interest-rate risk.

3. Stock index futures are financial futures whose

underlying financial instrument is a stock market

index like the Standard and Poor’s 500 Index. Stock

index futures can be used to hedge stock market risk

by reducing systematic risk in portfolios or by locking

in stock prices.

4. An option contract gives the purchaser the right to

buy (call option) or sell (put option) a security at the

exercise (strike) price within a specific period of time.

The profit function for options is nonlinear—profits

do not always grow by the same amount for a given

change in the price of the underlying financial instru-

ment. The nonlinear profit function for options

explains why their value (as reflected by the premium

paid for them) is negatively related to the exercise

price for call options, positively related to the exer-

cise price for put options, positively related to the

term to expiration for both call and put options, and

positively related to the volatility of the prices of the

underlying financial instrument for both call and put

options. Financial institutions use futures options to

hedge interest-rate risk in a similar fashion to the way

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Part 7 The Management of Financial Institutions

they use financial futures and forward contracts.

Futures options may be preferred for macro hedges

because they suffer from fewer accounting problems

than financial futures.

5. Interest-rate swaps involve the exchange of one set of

interest payments for another set of interest pay-

ments and have default risk and liquidity problems

similar to those of forward contracts. As a result,

interest-rate swaps often involve intermediaries such

as large commercial banks and investment banks that

make a market in swaps. Financial institutions find

that interest-rate swaps are useful ways to hedge

interest-rate risk. Interest-rate swaps have one big

advantage over financial futures and options: They

can be written for very long horizons.

6. Credit derivatives are a new type of derivatives that

offer payoffs on previously issued securities that have

credit risk. These derivatives—credit options, credit

swaps, and credit-linked notes—can be used to hedge

credit risk.

7. There are three concerns about the dangers of deriv-

atives: They allow financial institutions to more eas-

ily increase their leverage and take big bets (by

effectively enabling them to hold a larger amount of

the underlying assets than the amount of money put

down), they are too complex for managers of finan-

cial institutions to understand, and they expose finan-

cial institutions to large credit risks because the huge

notional amounts of derivative contracts greatly

exceed the capital of these institutions. The second

two dangers seem to be overplayed, but the danger

from increased leverage using derivatives is real.

K E Y   T E R M S

American options, p. 606

arbitrage, p. 595

call option, p. 606

credit default swap, p. 617

credit derivatives, p. 616

credit-linked note, p. 617

credit options, p. 616

credit swap, p. 617

currency swaps, p. 613

European options, p. 606

exercise price (strike price), p. 606

financial derivatives, p. 590

financial futures contract, p. 593

financial futures options (futures

options), p. 606

forward contracts, p. 591

hedge, p. 590

interest-rate forward contracts,