Moving from Regulation to a Modern Financial System

1
Moving from Regulation to a Modern Financial
System

• Broadening and Improving Risk Management by
  Creating Markets for Derivatives

Speaker Anders Reveman
2
Derivative products

• Derivatives are contracts based on or derived
  from some underlying asset, parameter, reference
  rate or index
• Most common financial derivatives can be
  classified as one or a combination of four types
• Swaps
• Forwards
• Futures
• Options
• Three primary forces created the financial
  derivatives
• More volatile markets
• Deregulation
• New technologies

3
Derivative products continued

• Deregulation started it
• Bretton Woods fixed exchange rate regime
  breakdown early 1970s
• Removal of government-established interest rate
  ceilings
• Volatile markets followed
• Inflationary oil-price shocks
• Wild interest rate fluctuations
• New technology beginning of 1980s accompanied by
  deregulation of financial markets created new
  ways to analyze information and break down risks
  into component parts
• Forwards
• Futures (standardized and cleared forward
  marked-to-market daily)
• Swaps (interest rate or currency)

4
Are derivative markets and products adding risk
or reducing risk?

• Derivatives allows the investor to decide what
  level and scoop he wants for his risk
• Before the derivative products were created, the
  only risk option was to adjust the leverage
  between the loans and the securities
• But financial derivatives are not really new..

5
The story of Thales a poor philosopher from
Miletus according to Aristoteles

• Thales had great skill in forecasting and
  predicted that the olive harvest would be
  exceptionally good next year
• He made agreements with several olive press
  owners to deposit what little money he owned to
  guarantee him exclusive use of their presses when
  the harvest was ready
• Thales successfully negotiated low prices because
  the harvest was in the un-known future and
  because the press owners were willing to hedge
  against the risk of a poor yield
• The harvest next year was rich and Thales could
  sell his option contracts at a good price
• If the harvest had been poor, he had not been
  obliged to exercise the options

6
The story of risk management when planning for a
40 year wedding anniversary

• We had saved 10.000 USD for the celebration
• I wanted to go to Aruba in the southern part of
  the Caribbean
• My wife wanted a diamond ring as a memory of the
  day
• I persuaded her to go to Aruba in spite of her
  worries for hurricanes in late November
• Solution
• Chances for hurricanes so far south and close to
  South America late November are small, so I
  bought a weather derivative contract for 100 USD
  that would pay out 10.000 USD if the wind at a
  specific observation point exceeded 40 meters/sec
  any time during the week we were there
• It was a successful wedding anniversary at Aruba
  with no hurricanes, but the reduced risk of a
  marriage disaster was well worth the extra 100
  USD paid for the derivative

7
Are derivative markets and products adding risk
or reducing risk?

• Swedish experience
• Interest rate futures traded OTC since 1984
• OMX (former OM) created a derivatives market in
  1986
• Strong focus on education and training of
  brokers, financial advisers and investors
• Reliable and transparent, completely
  dematerialized securities markets for equity and
  fixed income products builds the foundation for
  reliable derivatives markets
• Relative to the size of the Swedish economy and
  the size and turnover of its stock market, the
  Swedish derivatives market is the most developed
  in the world
• .with no Barings Bank disasters

8
The definition, transparency and control of the
underlying parameter or product is fundamental
for a derivatives product

• In the mature markets, derivative products have
  developed primarily as a means of laying off the
  market risk
• Well developed capital markets have acted as the
  hen laying the egg in the form of a derivative
  product
• Less developed markets have often uncertainties
  related to the underlying object and the
  information about the object
• In such markets, risk hedging on a derivative
  market can play a different and complementary
  roll
• Professionals on the derivative markets can
  assist the underlying markets with continuous
  analyses of risks and forecasts for those
  products where there exists parallel derivative
  and underlying markets
• This can support the development towards in all
  aspects mature and transparent financial
  markets.

9
What should Regulators do?

• More supervision than regulation as simple
  standardized rules would impair the banks
  ability to manage risks
• Trading organisation should carry the burden of
  managing the markets through self-regulation
• Government guarantees are no answers they will
  serve only to create moral-hazard behaviour by
  derivative traders
• Supervisory should focus on
• Increasing disclosure of derivatives holdings and
  strategy behind
• Appropriate capital adequacy standards
• Sound risk-management guidelines

10
Derivatives a summary

• Derivatives help organizations manage risk
  exposures
• Development of derivatives was brought about by a
  need to isolate and hedge against specific risks
• Derivatives offer a method of breaking risks into
  component pieces and managing those components
  independently