1

Role of Financial Derivatives in Managing Risk in Financial Markets:

Towards the Complex Exchange of Risk, Speculation, and Fundamental Value

2

Preface

This research is based on the study of financial derivatives as understood to be the most

violent objects of the financial industry. The first draft this research work was quite difficult

to integrate as it appeared to be discrete units with independent focus of financial risk with

role of derivatives on one side and fundamental value with financial fragility on the other.

Continuous change and repetitive readings have made it possible to formulate the intended

focus and a single line of argument for the four chapters. Seen initially as a very ambitious

project, this is quite close to what in my opinion is happening in our financial times.

August 2008

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Abstract

Financial derivatives have been under criticism for various instances of financial instability.

Taking that into account this research has been focused on analysing the role of derivatives in

contemporary financial markets. This study originates from the research on perception of risk

in financial economy and the innovations for controlling the future uncertainty by using the

derivative tools. Role of derivatives and understanding of risk has been examined to bring

forth the weakness and problematic nature of the concept of ‗fundamental value‘ of asset

prices in financial markets. This notion of fundamental value is broadly discussed in the light

of financial instability to provide the groundwork for observing the shifting perspectives on

new and complex forms of derivative tools that exist today. The role of derivatives in

financial economy has been under transition and this study uses different financial crises to

examine the shift in perception of more and more complex forms of derivatives. It outlines

that analysis of role of derivatives and their purpose of existence has to be observed in a

board view of the economy as a whole. Through various arguments on the nature of

derivatives trading, fundamental value, reconfiguration of risk in financial markets, the

weakness of asset price bubble theories has been brought out to some extent. However, this

study acknowledges the drastic consequences of derivatives trading and their use for

speculative nature of investments in financial markets it emphasises that there is a need for a

widening of the framework within which the role of derivatives could be analysed for a more

comprehensive view of the financial management tools that have become indispensible to the

global financial economy even with strong negative impacts on the economic stability of

various economies.

4

Acknowledgements

I would like thank my advisor Dr. Andreas Antoniades for his invaluable comments and clear

directions for building a sound base for research on the project. I would also like to thank my

colleague Ms. Nathalie J. Louge for her invaluable time for discussions and strong

encouragement for completing this thesis.

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Table of Contents Page

Introduction 6

1. Manifestation of Risk in Financial Economy 9

1.1 Ideology of Risk 10

1.2 Role of Risk in Financialization 13

1.3 Future Value and Financial Risk Management 15

2. Derivatives Theory, Use, and Effects 17

2.1 Theory of Financial Derivatives 17

2.1 Use of Financial Derivatives and Response of Financial Markets 19

2.3 Effects of Financial Derivatives and their Role in Financial Risk Management 22

3 Fundamental Value of Assets in Financial Economy 25

3.1 Investor Choices and the Concept of Value 25

3.2 Volatility, Asset Price Bubbles, and the Concept of Value 26

3.3 Financial Instability, Role of Derivatives, and the Concept of Value 34

4. Transition in forms of Financial Instability and the Criticism of 37

Financial Derivatives

4.1 Transition of Financial Derivatives with Financial Crises 38

Conclusion 41

References 45

6

Introduction

This research is a work on financial derivatives and their role in the economy. Financial

derivatives have come under wide criticism for their destructive nature in the financial

markets and the effects of same spilling into the real economy. It is important to understand

the reasons for which derivatives have come into existence in the financial economy and their

prevailing nature throughout the decades of developments in the global financial economy. A

normal question as to why derivatives exist (Steinherr, 2002) in our global economy has been

a strong debate in the contemporary literature on financial markets. Most theorists that argue

against the role of derivatives and criticize their purpose of existence (Dodd, 2002) initiate a

very crucial point of discussion. Financial derivatives have been innovated into ever more

complex forms and hence become a very important part of our global financial system and

have implications on the financial and overall economic stability of the world economies.

Proponents of theories on asset price bubbles (Minsky, 1986) underline the speculative nature

of investments is often associated as the direct consequence of the nature of trading and use

of derivative tools. These asset price bubble theories base their explanations of the drastic

effects that financial derivatives can produce, with the leverage (Harmes, 2001) available to

the investors to speculate on different financial assets, has a fundamental problem in the

nature that they build these explanations. The nature of these explanations has an orientation

to the concept of ‗Fundamental Value‘ of financial assets (Itoh and Lapavitsas, 1999) that is

problematic to define clearly and creates a weakness in the understanding that these theories

offer to provide.

So, this research attempts to breakdown the relationship between the risk of volatility

that is captured by financial derivatives and the articulation of value in terms of financial

assets that create the notion of fundamental value in financial markets. In order to analyze

this relationship it is very important to denaturalize the basic conceptions of risk in the

society, especially in the financial economy, and the inclusion of risk assessment to create

risk management tools that further continue to expand in realization of new forms of risk. The

analysis of risk society by Beck (1999) provides a substantial argument to observe the

importance of inclusion of risk in modern society. Through this understanding of risk as a

mode of creating opportunities towards new innovations, the financial economy is analyzed

and developments within the global financial economy are highlighted to indicate the

transitions that have lead to the increased importance given to risk management. The

increased need for risk management is interlinked with the rise of widespread use of financial

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derivatives. The break from dominance of the production economy and the transitions that led

to the rise of the financial economy during the late 1960s and 1970s has been the most

important point in the history of derivatives. As this transition was taking its shape the need

to control highly increased volatility and fluctuations due to inflation problems, currency

problems, debt defaults, and many other factors was rapidly increasing (Brenner, 2002). This

literature review on the growth of financial industry (Helleiner, 2004) provide a sound basis

for presenting financial derivatives as a socially constructed and need-driven innovation in

the financial economy, with its roots well ingrained in the events and circumstances in the

real economy that led to its deep penetration and firm control over the flows of financial

capital and the volumes of investments in financial economy.

Derivatives are presented through the theoretical explanations that outline the

relationship of hedging and speculation (Working, 1978) in the financial markets. This helps

to underline the original purpose of derivatives, i.e., ‗profit securing‘ for agents in the real

economy, and the contradictions thus arising due to their use for evident speculative activity

(Bernstein, 1998) in the financial markets. The focus of bringing forth this contradiction is to

involve the debate of the existence of derivatives with the very important role of volatility in

financial markets. Derivatives are driven by volatility and price change in financial markets is

most important reason for their existence. But the combined effect of the two factors

articulated have been used to indicate configuration and reconfiguration of risk that is

performed using financial derivatives. The financial risks have been distributed to through the

tools like derivatives but the spread of this concentrated risk creates further implications that

lead to new innovations in financial risk management. This leads us to reach to a cycle of risk

reconfiguration that automatically creates the need for further control the risk of volatility and

price change and other factors that create risk exposures within financial markets.

The argument that relates to the problems that this research engages with

encompasses the role of derivatives in the financial economy as instruments that control

volatility, yet simultaneously are driven by only volatility or price change for their existence.

With this contradiction the argument takes a step further to integrate the understanding of

fundamental value of financial assets traded in financial markets and the explanations of asset

price bubble theories that are based on this understanding. It is a conscious effort within this

integration of two different arguments, one indicating the role of derivatives and the other

disregarding the notion of fundamental value in financial markets, to bring out the

contradictions that are inherent to the financial markets and the overarching economic

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framework in which they work. These contradictions can appear in the form of existence of

derivatives even when they are strongly criticised to be the source of high volatility and

instability in financial markets leading to financial fragility and threatening economic

prosperity of different market economies, especially the emerging economies of the world.

For the purpose of arguing against any significant reason for the concept of

fundamental value, the same is put into perspective with a model bubble theory explanation

(Stanford, 1999). In building this argument various factors like price-overshooting (Harmes,

2001) and positive-feedback (Sornette, 2003) have been analysed against the theoretical and

practical framework of the bubble formation within financial markets and the real economy.

This argument that is put against the unclear notion of fundamental value in such

explanations does not undermine the occurrence of sudden asset price appreciation or cycles

of self-fuelling and short-term bubbles appearing in financial markets and economic

fundamentals, but it questions the basis of their reasoning that could be analysed within a

timeframe to make use of fundamental value as a notion describing such circumstances.

Underlying fundamentals for assets are argued as qualitative understanding of the market

participants, as they have a tendency to move with consensus-building and converging

expectations within these markets. This section of the research works on the relationship of

„irrational investors‟ (Shriller, 2002) and formation of value for financial assets within the

financial markets. There is also a close link that is provided between the role of derivatives in

creating financial instability and the failure of mechanism of value creation to associate with

the argument presented for the occurrence of financial crisis. This relationship highlights the

insignificance of notions of fundamental value for financial assets and its problematic nature

to be attributed to such relationships in order to understand the nature of financial instability.

The incapacity of fundamental value to emphasize any concrete reasons for instability or the

destructive nature of derivatives but interlinks the two by providing focus on financial

instability and its changing nature with the developments in derivative markets over time. In

order to capture this change East Asian Financial Crisis (Dodd, 2002) and the recently

observed Subprime crisis (Pollin, 2008) has been put to comparison. This comparison

provides the fundamental change that derivative markets have created in the nature of

financial instability by spreading their effects into deeper corners of the society as they engulf

newer forms of financial asset classes.

In essence this thesis starts to articulate risk, especially in financial economy, to form

a basis for the denaturalization of the existence of derivatives. With the deconstructed idea of

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derivatives through its theoretical understanding and the contradictions that this theory

creates with the practice of trading of derivatives in financial markets an important argument

is drawn for an alternative view to the prevailing financial derivatives, their existence and

innovation in the financial economy. The understanding of derivatives and the nature of rapid

developments in financial economy since the 1970s underlines the problematic nature of

fundamental value for financial assets. This problematic nature of the notion of fundamental

value in financial markets is viewed in perspective of the asset price bubble theories to

underline their weakness and also to reiterate the insignificance that diminishes the role of

fundamental value for financial markets. The argument is further broadened to the different

aspects of financial instability that are associated with the role of derivatives in the financial

economy. The nature of explanations based on fundamental value do not fully embrace the

framework in which the financial markets situate themselves and the imperatives that the

developments in derivatives markets and financial industry in general have created for a new

understanding for the existence of derivatives in the financial economy. The financial crisis in

different times have been analyzed to portray the changing nature of derivatives and their

penetration into the different fields of our society and the implications that this has for

stability in financial markets and the global economy as a whole.

1

Manifestation of Risk in Financial Economy

We start by the description of the ideology that drives risk (Beck, 1992) and its assessment in

the financial economy. Using this ideological projection of risk in our society, an argument is

presented on the changed nature of risk in the world economy since the 1970s, leading to an

increased use of financial risk management tools. Financial risk is managed by tools that

enable the creations of a price in the present for an asset or commodity which will be

physically traded in the future. Originally the purpose of such tools was to secure the profits

of producers and consumers and render smooth cycles of production and delivery, at a future

date. The concept of „Future Value‟ in this argument becomes the reproduction of risk as a

mode of creating new avenues for ‗profit generation‘ rather than ‗profit securing‘ against

those identified risks (Steinherr, 2000). This argument is put against the theory of financial

derivatives and futures trading to understand why derivatives are assumed to create

value/expectation from an uncertain future. The argument engages with the criticism of the

10

role of derivatives as tools of risk management and underlines the pervasive risk

vulnerabilities induced by such financial innovations.

1.1 Ideology of Risk

Risk has always prevailed in every society and its organization, in the history of time. It is in

the perception of risk within a particular society or a system that creates the notion of

estimated risk. It is an idea that can be observed surfacing or amplifying with further

developments in various fields in different societies around the world. Risk can manifest

itself into many forms like the risk related to agricultural produce, weather unpredictability,

production failure, unforeseen accidents, interest rate or exchange rate change, supply and

demand imbalance, etc. All these factors, although they constitute very few modes in which

risk can be understood within an economy, appear to have relevance in respect to how the

different agencies within a particular economy perceive and calibrate the risk related to each

of them. If we go back to ancient times, knowledge about anticipated events was a

prerogative of an esoteric class of oracles and future predictors and the risk associated with

the anticipated future was calculated in terms of the possibility of a certain event happening

in favour of the agency involved. As noted by Bernstein (1998), the factor that separates the

modern society from their past is their understanding of risk and efforts to master the tools

that can control the unpredictability that is associated with risk. With a theoretical standpoint

of institutionalism in the literature on political economy, the modern society is characterized

by its nature of increased risk-taking that becomes the defining quality that drives this

modern society. For example, ‗the Frontier‘ or the settlers were considered the more risk-

taking and practical headed section of the American society which shifted from east to west

with an idea presented as the survival of fittest or the social Darwinism as articulated by

Thorstein Veblen in Van Der Pijl‘s (2007) analysis of Pragmatism and Institutionalism.

For the contemporary society risk has manifested in more complex forms as compared

to the past. These complex forms result from the inventions and innovations in the social

structures, the economic systems, and the political frameworks within which these societies

have evolved. To understand the changes in the global economic system in the 1900s,

especially the transition of different economies in the world from 1960s to 1970s, there is a

conscious effort to bring out the incessantly growing knowledge, importance, and impacts of

risk associated with economic systems and the financial systems. According to Ulreich

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Beck‘s (1992) idea of the modern society as a risk society, the role of risk and its inclusion in

the modern society serve as opportunities for generating benefits, which could be economic

in case of the financial economy. Transformations in the modern society have been

continuously producing new and different forms of risk. His ideological focus is on the tools

that can minimize or channel the risk associated with the continuously developing modern

society. Beck (1992) refers to this modern society as the ‗risk- distributing‘ society,

acknowledged in the field of financial economy. This follows the recent developments in the

global financial economy since the 1970s and the break from a working and profitable

productive economy into the contemporary reoriented financial economy. This shift

highlights the importance of risk through its new perception and its effect on the increased

need for its management. This more detailed conceptualization of risk has created a new

dimension through which the financial economy is observed. Many events can be accounted

for the new perceptions of risk within the financial economy that have created a need for

innovation in the tools that can manage this increased financial risk. However, the argument

extends beyond the appearance of risk management.

In Beck‘s (1992) ideology, this risk management calls for new and innovative forms

of tools to control this risk and to minimize the effects of the risk by making certain of the

knowledge of uncertainty. Yet, these new risk management tools are in themselves origins of

new forms of risk that come to the knowledge of the modern society. Particularly, in the

financial economy and its participants in case of this research, a threat is posed to the idea of

risk management in the global economy as governed by developments in finance. In the last

three decades of history of rapid financial developments, it can be observed that risk

management tools in the financial economy lead to the creation of new risks that appear in

various forms like market crashes, economic slowdown, weakening of the productive sectors

due to high dependence on the financial growth for most economies, etc. Specifically, the

growth of derivatives as tools of financial risk management have been continuously

innovated into more complex forms to manage the ever increasing risk that reappears with

new developments in efforts to control and minimize the risk associated with the financial

economy. With financialization and the creation of the standard derivatives market within

major economies of the world, the risk has been distributed. However, this development

incites the production of new forms of risk has consequences for the wider community in the

financial economy.

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Taking into account the developments in the world economy in the 1900s, there

appears to be a clear distinction between the role of risk control before the Great Depression

of 1929-30 and after the economically destabilizing events that followed the 1929 market

crash, after World War II. After this crash, economies were strongly regulated for their

economic revival and the efforts to control speculative movements of capital. Yet, the real

changes within the financial economy appeared in the transitions in late 1960s and the 1970s.

Risk was viewed with a new dimension in the rapidly growing world of finance (Bernstein,

1992). The increased manifestation of risk in an economy requires a further innovation of the

tools that can control the risk and manage the unpredictability associated with that risk. Risk

and management of risk triggers a vicious circle of self-repeating cycles where control of risk

creates new forms risk by pushing the tools of its management to pose these new forms of

risk. This cycle can be illustrated by agriculture as affected by the risk of weather changes or

unpredictable turns that can harm the produce or create situations such as famines.

Continuing on this example, the tools of monitoring the weather inevitably involve

factors like failure of monitoring, precision of results, and information asymmetries. This

creates further risks, and in turn, requiring further innovation to create systems to avoid the

risk and cease the unpredictable nature that is understood in the new risks that have appeared.

Focusing on the financial systems of the world, there have been many developments in the

understanding of risks associated with it (Steinherr, 2000). The most innovative tools that

have been created to control the financial risk are derivatives. Derivatives control the risk of

various currency movements, interest rate changes, commodity price fluctuations, and several

other factors that can affect the profits and revenue of investors like individuals, corporations,

and governments. However, the risk management technique, as we understand it, further

poses new risks that have to be managed with further innovation in the field. Thus,

derivatives used in the financial markets have evolved for a long time and exist in very

complex forms in the contemporary financial system as compared to the past. This complex

nature has been drawn by the need of further control on financial risk due to surfacing of new

its new forms with innovations in the financial system. To comprehend the cycle of risk

related innovations in the financial system it is essential to examine the changes that have

appeared in the global economy between the 1960s and the 1970s.

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1.2 Role of Risk in Financialization

As Brenner (2002) cites in his analysis of the 1950s and 1960s, major economies in the world

were inclined maintain the capital controls and was followed by the deregulation of most

economies recuperating from the drastic effects of the WWII. This was a period of domestic

economic growth, with minimum levels of international financial flows due to the capital

controls maintained by economies like the US, western Europe, and Japan. During this period

of domestic economic prosperity there was little pressure of international competition on

corporations, which saw a continuous rise in their profitability (Brenner, 2002). Within these

production economies, the risk was inherent to the process of production and changes in the

supply and demand, specifically within domestic markets. The risk appeared to be controlled

by the maintenance and creation of high demand within the economy as to stabilize again

from the destabilizing effects of the World War II. Understood in this way, the risk is

associated with a production economy within a framework of capital being used for

generating goods and services within a strongly regulated capital flow environment.

Therefore, it appears that the risk had lesser dependence on external factors and thus was

controlled with appropriate policy decisions made by different political units within these

economies.

However, Brenner (2002) strongly argues against these most embraced explanations

for decreasing rate of returns and incapability of states to regulate for a revival of increase in

profitability starting in the 1960s. Due to factors like like falling domestic demand and the

problems of ‗overproduction‘ and ‗overcapacity‘, this period comprised increased

international competition (Brenner, 2002). These reasons lead to falling profitability for

various corporations around the world, especially in economies like US, Germany, and Japan.

This appeared to promote a disinterest in maintaining industrial capital within the productive

economy and to maintain tight control over financial capital flows. These economies saw

flight of productive capital to offshore deregulated financial centres like the „Euromarket‟

(Helleiner, 2004). This initiated a new age for financial capital. Deregulation was starting to

appear in most major economies by the 1970s. Furthermore, the US economy was under a

problematic condition because of the 1973 oil embargo (Helleiner, 2004) which inflated most

commodity prices and lead to the depreciation of the US dollar against other major currencies

in the world. This placed further pressure on the producers in the real economy and slowly

under transition the financial economy attracted more capital flows. This marked the

financialization of various economies around the world.

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While the financial capital flows were becoming prominent during the mid 1970s,

there was the rise of the global financial capital centres like London and New York, where

capital flows were heavily deregulated. These new developments within the global economy

were accompanied by new forms of risk manifesting themselves in various complex forms

such as risk of inflation, currency pressures, and fluctuating profits in the production sector.

As articulated by Helleiner (2004), most economies following the path of economic

deregulation as financial capital flows became increasingly attractive due to reasons like the

prominence of major economies (US and UK), which were following the path of deregulation

and pursuing other economies to follow by using their strategic advantage over international

trade and financial markets dependencies. Other factors include the attractive returns on

financial capital investments and the deliberate efforts of most governments to refrain from

controls over financial capital flows due to the risk of being left out from the financial

developments (Helleiner, 2004). Cohen (1996) articulates that technological change as

creating a movement towards financial capital flows and the attraction of American Financial

system as also responsible for the deregulation of different economies.

These factors indicate that financial markets were becoming increasingly important

for economic growth and revenue generation through investments. With deregulated

economies and financial markets, the capital movements accelerated their pace and resulted

in an increased threat to economic instability due to the same factors that were responsible for

stimulating growth in the economy. The risk associated with financial capital flows was

clearly outlined by events like hyper-inflation in the in 1979-80 and the debt crisis that

occurred in Latin America in the 1980s (Kindleberger, 1996). This risk appearing with the

growth of financial capital flows and with numerous economies opening up to deregulate

their financial markets incarnated a new appearance of risk in such economies. These risks

had existed but had been controlled by government interventions or other agencies

maintaining policies so that these financial risks did not appear as unpredictability in the

future. From one perspective, the reasons why deregulation was being undertaken provides

significant evidence that these economies were deliberately making policy decisions that lead

to a „high-risk high-reward‟ environment within these economies and in the international

markets. It is only the difference of how these risks have taken different forms in different

economies. For instance the deregulation of the banking system lead to heavy lending by the

private banks to developing economies with an associated risk of default. This is illustrated

after the Latin American crisis when most private banks resorted to risk management

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innovations like collaterals and portfolio diversifications (Das, 2005). This instance showed

that as financial markets gained more strength, the significance of the risk inherent to the

financial systems of the world increased. Higher risk based forms of profit generation

required more sophisticated tools of risk management.

During the late 1980s came the wave of widespread use of risk management tools

called „Derivatives‟. It has been documented that the concept of derivatives as an innovation

is not new to the global economic system as going back into history derivatives have been

used as early as the 15th century (Bernstein, 1998). During the 1800s futures were used in the

London Exchange to protect against the risk of price fluctuations. Derivatives are tools

through which investors can protect their profit margins against the possibility of price

change or occurrence of an unfavourable event, but it was only since the 1970s that

derivatives gained a considerable significance in the financial economy. This was because the

volume of the financial transactions had become increasingly large and thus created

imperatives for the investors to widely use derivatives for securing profits against

unavoidable price movements. Derivatives have been a result of increased risk in the

financial economy. However the degree of derivatives‘ control on the risk within a financial

economy is still questioned. Such a question requires a further understanding of the basic

fundamentals on which financial derivatives are based.

1.3 Future Value and Financial Risk Management

A financial derivative is a tool which derives its value from an underlying asset, where the

asset can be anything that exists as a tradable entity (Bryan and Rafferty, 2007). This value is

derived on the future expectation of the asset price movement to be experienced by the

investors involved in the transaction of the particular asset. This introduces a risk associated

with the asset price movement. This risk is calibrated in the form of price differentials and the

observed value of a derivative derives itself from the expected future price of the asset. Risk

as an opportunity is used in the form of future expectation that creates a value of the

derivative representing the risk. The uncertainty of the future is quantified as a value that

signifies the change in the price of an asset that is expected by the investor. This process uses

derivatives to protect profitability against price movements. It is a very interesting

phenomenon that uncertain futures are put into values that can be traded on the secondary

markets with a convergence of interest on the expected value on a future date. This

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transforms risk into opportunities of generating profits by trading derivatives with a view on

future expectations. But risk will always remain a risk as it cannot be reduced to any other

form. Derivatives, as risk management tools, can only spread or distribute the risk of price

movements rather than reducing any risk that is associated with the future change in price of

the underlying asset. Hence, derivatives cannot be said to control risk but spread risk so that

producers or consumers have the opportunity to secure their profits against possible negative

price movements.

This poses the essential question that if derivatives secure profits of the producers and

consumers than who bears the cost of a price change? To understand the role of financial

derivatives as matching savers to investors (Stanford, 1999), it is essential to see identify the

savers and investors that are involved in a financial transaction over a futures contract. On the

other side of a derivative transaction is the ‗speculator‘. Speculators bet money on the price

change in the opposite direction as the producer or the consumer they are transacting with

(Steinherr, 2000). Therefore, speculators are looking to generate profit against a possible

price movement. This is the ideological divide on the use of derivatives. With the definition

of this financial innovation in the form of derivatives, they are profit securing tools that can

be exercised by producers or consumers to secure profits. Yet, simultaneously they are being

used by speculators to generate profit by using the same tools that are in place to secure

profits for the agents from the real economy involved in the transaction.

To elaborate on the origin, existence, and role of derivatives in the global economy

the next section engages with the financial derivatives in relation to the financial markets

theory. This helps to extend the argument that has been outlined in this section in relation to

risk and risk society to the risk in financial economy and innovation of risk management

tools. The problematic and contradictory nature of the existence of the financial risk

management tools as briefly outlined in this section is presented to form the basis of the

argument. The argument against financial risk management tools is necessary focus and be

able to identify the relationship between risk of volatility in financial markets and the

methodology that explains the control of this risk. In essence the motivation is to interrelate

the concept of increased risk due to advancements financial economy and the role of this risk

in the ways it affects the framework of financial systems and the economy as a whole.

17

2

Derivatives Theory, Use, and Effects

2.1 Theory of Financial Derivatives

The fundamental argument in theory of futures market presents financial derivatives as an

institutional mechanism of risk management. Futures markets can be used by producers and

consumers to sell or buy a certain actual physical commodity or other financial assets on a

future date at a price that is decided in the present. This mitigates the risk of price change that

could create unintended costs for the buyers and sellers. In order to manage the risk of price

change, one can hold a futures contract in the futures market to either buy or sell a particular

financial asset in the present to be physically sold or bought on a future date. The standard

futures contract describes a certain quality and quantity of the commodity or the asset to be

delivered on specified date and place, in the future. In financial literature, the process of risk

aversion associated with price volatility in a transaction made in the actual physical

commodity market is made by making a concomitant opposite transaction in the futures

market, where this process is called ‗hedging‘ (Johnson, 1978). Hedging of risk in the futures

market is a method by which buyers and sellers can exercise a „price lock-in‟ for ascertaining

a preconceived cost or return. Futures trading is considered important for an asset or

commodity which has a lag between the demand and actual supply of the physical

commodity, for example, agricultural products and base metals etc. Based on the expectation

of price fall the sellers hold „short‟ future positions while buyers, with an expected price rise,

hold „long‟ future positions (Johnson, 1978). Although, hedging strategies wipe out the

possibility of any profits that could be made if the prices were to go in the opposite direction

than expected, it is still a mechanism for price stability in the international trade of physical

commodities and financial assets.

According to futures market theory, the derivatives traded on the futures market help

create an efficient allocation of risk and, therefore, demonstrates sustainable price levels for

different commodities and assets that are traded on any exchange (Working, 1978). This is

based on the effect of a broad and transparent platform for demand and supply which

restraints any disproportionate influence on price determination of a particular commodity.

The underlying assumption for the explanation of existence of a price discovery mechanism

is that the supply and demand factors related to the market are based on the actual physical

18

trade of the commodity or the underlying asset and there is a long-term (contract length) view

for an appropriate price for buying or selling the financial asset on a future date. So, hedging

strategy in a futures market is interpreted as an insurance against any loss bearing price

movements related to this asset.

Due to this interlinking of different financial asset prices, the reflection of any

individual financial asset price is going to reflect the anchored value dependent on its

relationship with all other financial assets, or the relative value. Brian and Rafferty in their

analysis of the role of derivatives on the economy introduce two concepts of ‗Binding‘ and

‗Blending‘, where binding is of the future value of a financial asset into the present and

blending is the swift convertibility of different financial asset forms, like swaps for interest

rates to commodity futures (Bryan and Rafferty, 2006). This view is problematic in terms of

analyzing a derivative market which is based on the assumption of „real‟ and „rational‟

valuations of future prices in the present. With this assumption the whole system of

derivative pricing gets deteriorated, as in practice the pricing of financial assets in a futures

market does not necessarily reflect the real „anchored‟ future value. If this assumption was to

be correct, abnormal price fluctuations in stock and futures markets would cease to exist and

derivatives would become the real reflection of demand and supply created by forces of

production and consumption.

When Brian and Rafferty comment on financial asset pricing ‗beyond speculation‘,

there arises an inherent question as to why the speculation would exist if there was a real

reflection of prices in any financial market. Speculation is an activity that is fundamentally

motivated by the market oriented profit maximization strategy (Venkataramanan, 1965).

Theoretically speculation supports a derivative market, like that of the commodity futures

market, by ensuring that changes that appear in financial asset values due to price

fluctuations, following the changes in demand and supply, are evened out by speculating in

the opposite direction of price movements. So, if the price fluctuations lead to asset price

appreciation, the speculator would sell and in case of asset price depreciation the speculator

would buy, therefore, correcting the price value of financial assets through trading in futures

markets. In theory this mechanism is useful as it would stabilize the underlying spot prices

(Sunni, 2006) for commodities through trading in the derivatives on the commodity futures

exchange.

19

2.2 Use of Financial Derivatives and Response of Financial Markets

Futures markets consist of the following two broad divisions of actors/agents - Hedgers and

Speculators. Fundamentally, hedgers engage in risk aversion of price changes in the future by

buying or selling a futures contract at the present price for a future delivery of the financial

asset or commodity. Speculators, on the other hand, are actors which invest in the futures

market to profit from the price change of a certain financial asset, or an underlying

commodity as in the case of commodity futures, based on the expected price fluctuations. As

the futures markets have witnessed that the majority of the trading in popular commodities or

critical financial assets is undertaken by speculators (Minsky, 1986) as compared the volumes

of futures contracts used by hedgers, there appears a contradiction to the original argument

provided by the market oriented proponents of the futures market that hedgers and

speculators balance out the price fluctuations that can occur in the financial assets or the

underlying commodities. The contradiction arises because the more the speculative activity

exists the more will be the expectations of a price change in the underlying commodity, as

speculation dwells on price change or price volatility.

So, derivative tools in the form of futures contracts, swaps, etc. are not just basic tools

to hedge against the risk of asset price changes in the future, but an important mechanism

through which a large number of investors engage in making profit without having any direct

relation to the financial asset or underlying commodity that they are trading in. For example

in the case of volatile base metals or fluctuating currencies, it is an added advantage that the

price volatility is very high which in turn attracts high volumes of speculative activity.

Volatility is a major factor in speculation as it provides the investors with short-term

investments to make profits by trading against frequent price changes with leverage of low

capital costs and transaction costs (Brown, Crawford, and Gibson, 2008). Derivatives have a

form known as options (Bernstein, 1998). Highlighting their use in the financial markets can

provide an elaborate understanding of the leverage that is provided to the investors, or

speculators in the financial markets, with which they can take higher risks for profits while

hedging against a maximum permissible limit for a possible loss into the uncertain future. As

Bernstein clearly outlines in his analysis of derivatives and financial risk, options are the

most convenient form of financial investments for volatile markets.

20

Futures trading has a very important aspect that provides incentives for investors to go

beyond the traditional methods of trading in futures markets, especially with volatile

commodities and other regularly fluctuating financial assets. In futures trading the investors

only need a margin, which is only a small percentage of the total cost of the actual physical

commodity trade or an actual financial instrument transaction (Ciner, 2006). This provides an

extreme leverage to the investors trading in a futures market because it generates avenues for

traders who are not involved in the actual commodity transaction or with the underlying

financial asset, but only identify the short-term outlook for profit motives vested in expected

price change. This creates a potential condition for the use of speculative activity by even

those who are hedging their risk exposures on these markets, in the attraction towards earning

extra profits by engaging in investments for generating favorable price changes. Enron was

an American energy corporation which went bankrupt in late 2001 due to their shift from the

productive business of electricity and gas to large risky exposures in energy futures lead to

massive losses. These losses were attempted to be hidden by fraudulent accounting

principles, but revelation of such irregularities lead to the Enron debacle (Blackburn, 2002).

So, there exists no clear line between the different actors involved in futures trading that can

classify them as hedgers and speculators. Also, speculative capital generates large profits

during the times of favorable investor expectations but such risk exposures often lead to

massive losses to real corporations and real units of production and consumption within an

economy.

As stated by Jim Stanford (1999): “Financial Markets are a medium to match savers

with investors and thereby fuelling the process of economic growth”. Financial industry

works as the intermediary to manage the flow of capital between different economic agents to

stimulate greater investment in the real economy for economic growth. The stock market,

theoretically, is an institutional setup to generate new financial capital that can be used in the

by industry in the real economy as new investments. Contradicting the theoretical basis and

framework of financial markets, especially the futures markets, in reality these markets have

become self-indulgent entities of exploding financial capital growth which is then reinvested

in the same financial setup further aggravating the process of capital growth. The creation of

new financial products as a conscious process of financial innovation is a method to contain

the flow of capital with in the financial industry to create a vicious circle of reinvestment of

capital raised from finance into new financial assets. In practice the relation between the

industry in real economy and the investments made in it are arguably not generated by the

21

financial capital formation, as addressed by the theoretical framework of finance, but instead

are entirely funded by the internal capital flows of the firms (Stanford, 1999). Therefore, it

becomes evident that the financial investments made by corporations are limited to a short-

term outlook towards industry performance, which further advocates for the speculative

nature of investments within the stock markets, and do not serve as the determinant of any

major corporate investments within the industry or real economy.

The futures markets or particularly derivatives run on speculation of asset prices.

Volatility of currencies, bonds, stocks, futures market indices, etc. is crucial towards the

process of increasing rate of returns on investments made into such financial assets.

Fluctuations in asset prices are a natural consequence of the financial risk management tools

that are traded in financial markets. The uncertainty of prices is reflected as volatility of the

parameters governing the growth in real economy. As the financial markets and the real

economy converge at factors like Interest Rates, Currency Exchange Rates, Securitization of

Real Assets (like mortgage backed securities), Commodity Futures, etc. there is a clear

interdependence of the two. These factors define the capacity to which the real economy can

expand, borrow, and invest to maintain a methodical advance towards economic growth. In

the same context Kurtzman suggest: “This tug of between the real economy and the

speculative economy, while adding costs to the real, garner profits for the speculative. The

two are in a way, in conflict with each other; not always, but usually. And they interact in

ways we do not fully understand“(Kurtzman, 1993)

Financial Markets have a tendency to overshoot in either direction, positive or

negative, depending upon the inclination of the economic agents, whether government or

investors, towards economic stability, growth credibility and other indicators of soundness of

an economy. As Harmes puts in his argument that overshooting is a consequence of the false

signals provided by the ill-representation of the „true‟ value of assets when markets do not

operate efficiently causing poor economic synthesis and decisions. Overshooting of a

currency, as in the case of the 1994 Mexican Crisis, is based on the high value of the currency

relative to its true value in the international exchange market which creates a fundamental

flaw in terms of overpriced currency. Due correction in this flaw creates a heavy devaluation

of the currency leaving it with a negative overshoot which leads to a currency crisis situation

(Harmes, 2001).

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2.3 Effects of Financial Derivatives and their Role in Financial Risk Management

Derivatives have an impact on the financial economy as well as the real economy. The most

important role of derivatives is to redistribute the risk associated with price changes borne by

the productive sector of the economy. As put in their analysis on derivatives Brain and

Rafferty articulate that system of derivatives perform the role of an anchor to the pricing

mechanism of all other assets. In this view point on the role of derivatives there is an

indication to the dependence of all assets to the existing complex network of derivatives that

creates an elaborate mesh which introduces interdependence of events that results in price

change of other assets (Bryan and Rafferty, 2007). In other words this network of derivatives

that are used for a variety of different asset classes creates interlocks within their price

determining mechanisms, as each event has an impact on different asset‘s values due to these

inter connections created by this network. For instance interest rate change, whether be

LIBOR or Federal Rates or Yen interest rate, all have an impact on the financial flows into

other asset classes resulting in a new adjusted level of stability in different asset prices. Yen

carry trade (Hartmann, 1998) is one of the most evident examples of this network of

interlocked asset classes due to price impacts of Yen borrowing into other liquid assets like

equity derivatives in other markets. With a change in the interest rate of borrowing Yen, the

Japanese currency, there is a direct consequence on how corporations and institutions

borrowing from the Japanese government react to this change by changing their positions in

other invested markets. This appears in the form of a structural change in financial flows,

which are highly liquid and create problems for various financial market products as this

nature of liquidity of capital on most assets traded in these markets allow capital flight

without regulation.

To understand this further we have to introduce the role of derivatives as suggested by

Brain and Rafferty to a more fundamental level of its association with the underlying assets

and commodities. In relation to the theoretical argument of derivatives it is explicit that

derivatives are risk management tools that mitigate the financial risk involved in market

economies. In practice derivatives trading do not involve the principal or title of the

underlying asset, commodity, or an event. Their purpose is to capture the change in this

principal price of the underlying asset class to which they associate with. This price change

could appear in the form of appreciation or depreciation of the trade value of assets on the

stock market, precisely the futures market. This change could be a result of the imbalance of

supply and demand, economic or political changes, financial capital flows in and out of any

23

market, etc. The importance of price change, in respect to derivatives, lies in the value that is

created or lost in the event along with the factor that influenced the change. Each factor has

its own impacts on the network, as is understood as a system of derivatives that interconnects

and in turn influences other asset prices based on this change. The risk in financial markets is

the price change that leads to negative or positive impacts for different agents involved in

these markets depending on how the agents bearing the risk of price change are exposed to

the instruments that engage with this risk, i.e., the positions that they hold in the futures

markets following their expectations of price movements (Steinherr, 2000). The role of

derivatives is to consume this risk by providing tools to these agents, like the financial

institutions, governments, investors, producers and consumers from the production economy,

etc. having exposures in financial markets to create positions through the use of popular

financial derivatives like futures, options, swaps (Dodd, 2002) based on their expected and

calculated projections of certain price movements in the uncertain future.

So, derivatives are contracts that are able to configure and reconfigure risk in the

financial markets. The configuration of risk that is defined by these contracts depends on the

nature of the contract and its level of expected returns. High level returns operate on high

risk, where change in conditions or future events create drastic changes in profits of the

investors utilizing these tools, like Credit Derivatives (Das, 2005), which is the focus of

criticism in the contemporary literature on recent innovations in financial derivatives. The

capital employed in such derivative instruments is highly mobile due to its deregulated nature

and creates implications for not only the investors but to the total economic stability of

developing or emerging economies. The liquidity of assets in the secondary markets init iate

new forms of risk as the derivatives are continuously emerging into more innovative and ever

complex forms to mitigate and control the risk involved with this increased liquidity. The

criticism of liquid assets, that create implications of instability in the financial markets,

focuses on the rapid movements of capital. The capital flows have been a result of the

widespread standardization of the derivative markets and close integration of most financial

markets of the world. This integration of financial markets helps the financial risk to spread

in a more diverse geographical form but simultaneously creates chains of interconnected asset

classes that influence each other through a mesh of dependent factors. Derivatives used to

control risk have come under criticism due to the volatility they introduce in the price

movements of different asset classes depending on the liquidity of the underlying assets

(Toporowski, 2000). If we analyse the risk that is associated with derivatives based on its

24

origination, which is the price change in asset commodity value, then we can draw an

extension of this risk into the concept of fundamental value for the financial assets and

commodities.

Derivatives do not trade on stocks or bonds, events or changes in conditions,

commodities, etc. Derivatives trade directly and only on uncertainty. That is the purpose of

their existence and their only link to secondary markets, where uncertainty is to be

minimized. Risk that derivatives work upon is not directly associated with a fundamental

value of the underlying asset, rather the derivatives engage with the change in price or

principal of the asset‘s trading value. So, the derivative trading becomes relevant only for

volatility in the financial markets and is not in direct correlation with the fundamental value

of the assets that are being traded in the derivatives market. Fundamental value becomes a

superficial argument in terms of derivative trading, or in general for financial markets,

because the notion of arriving at a fundamental concept of value for an asset is oriented from

the processes of production and consumption in a productive economy and cannot be

channelized into the financial economy in the same manner as is arrived at in a production

economy (Knafo, 2007). The reason for this divide is that the productive economy has the

capacity to bring in the value for inputs and create a margin of profit that leads to a

fundamental value of any asset that is being produced. But in the financial economy, the

analogy of inputs and profit margins does not find a place as investors are neither putting

physical labor nor any other form of inputs, except for investing money in the form of

financial capital on an expected future value that can maximize profits or secure their profits

by hedging against unforeseen losses on the invested capital.

So, even if there was a concept that can lead to a fundamental value for different

assets in the financial markets, it can only reflect the convergence of market expectations

over a desired price for any asset or a commodity over an elongated period of time. Contrary

to the idea of fundamental asset price values in financial markets is the observed fact that it is

possible for a market to hold asset values at a certain level during the stability of its index

(the cumulative value of major stocks traded on that financial market) and the particular stock

and its futures prices to be stable at a certain time period, and then completely change to a

new stable level in a future time with respect to its past levels after a sudden rise or fall in the

financial markets. In other words, if asset prices can be stable and acceptable at level A at a

particular point of time T1 and be stable at level B at another point in time T2, not very

different from T1, then what is the fundamental level at which the asset prices should have or

25

would be based on. This creates a contradiction for analyzing the existence of financial

markets and the tools that are used within these markets to mitigate risk through the notion of

a fundamental value for these financial assets. This contradiction will be brought to light in

the next chapter which takes up fundamental value from its roots and deconstructs the

understanding of fundamental value in financial markets.

3

Fundamental Value of Assets in Financial Economy

3.1 Investor Choices and the Concept of Value

A neo-classical understanding for the value of an asset is based on consensus creating

systems that lead to convergence of expectations around a fundamental value of a particular

asset class (Kindleberger, 1996). This viewpoint is based on assumptions that markets are

perfect and competition in the market is the mechanism through which pricing and valuation

of different assets that are traded on the stock markets can be achieved. This provides a

theoretical argument for the functioning of financial markets through a notion of market

expectations converging to create asset values and the changes in asset prices which are

determined by perfectly informed investors that take rational decisions based on the available

information and taking into account the historical information. Future uncertainty in the

markets is a result of changing trends in how investors react to change in information and the

underlying fundamentals of the assets being traded. This uncertainty is transformed into a

certain value in the future through historical averages and present information that create

investor opinions to act for creating a consensus towards the present asset prices. In this

explanation of future value and change in market expectations, information plays a

significant role. All information is available to the investors, who in the neo-classical

reasoning, are perfectly informed and able to arrive at certain prices through the use of the

present information and comparing past trends with current change in market conditions. The

use of information is assumed to be complete and decisions of investors based on rational

choices that are made by the use of the change in information available.

26

Many theories contradict this neo-classical view point by suggesting that often the

new information available to the investors is weighted differently as to the historical averages

that are available (Bernstein, 1998). The investors are affected by change in information. This

leads to reactions based on partial information and overarching market opinions, hence

rendering not completely rational choices made by the investors. A contradiction in the

rationality of the investors and the investor opinions building in financial markets reflect the

imperfections in these markets. According to these theories that criticize the neo-classical

interpretation the rational choice investors are not fully rational beings, basing their choices

on full awareness of the conditions in present and the past. Furthermore, these choices are

derived from the opinions of investors mostly uninformed of mathematical models that

attempt to explain the risk and management of risk for change in financial markets, reacting

to present conditions with the most recent events and information available. This in turn

forms the basis for change in asset price values (Steinherr, 2000).

Market events are driven by antecedents and political, economic, and social

circumstances that govern the nature of rational choices that investors exercise to make

profits. Even when most assumptions call investors rational beings, these choices are not

entirely rational due to use of incomplete information, tendency to follow market trends, and

change in conditions creating different opinions among the myriad of investors. An

institutionalist view point supports this idea of not fully rational investors, due to the reason

that investors who are most informed are in the best position to make use of their resources to

come to the best possible opinion for reacting to change in market conditions as compared to

the choices made by partially informed investors (Shriller, 2005). Thus, the asset price

change is a convergence of choices made by investors according to the information available

to them and it constitutes a combined effect of the choices made by fully informed, partially

informed, or uninformed investors. This convergence of market opinion does not reflect any

substantial weight to form a basis for the values that financial assets are traded based on the

choices made by various investors.

3.2 Volatility, Asset Price Bubbles, and the Concept of Value

If we look closely into the working of the financial markets, there exist inconsistencies

regarding the financial market institutional framework that might come to rescue the notion

for a fundamental value for assets. The first rudimentary problem is the pricing of assets in

27

the financial markets. Due to the unavailability of any fixed mechanism or method to arrive at

any stock‘s price or its‘ trading trends in the future, the value of these assets is a reflection of

market expectations based on the variable use of the information that is at the disposal of

various investors participating in these financial markets. The second problem is the trading

of any asset‘s futures in the futures markets. Futures are based on the value that the

underlying asset will create by a change in its price in the favourable direction, which could

be either positive or negative, before the expiry of the contract for the particular derivative

tool. Futures can be traded in the futures markets, or secondary markets, for generating

profits or securing profits. The inconsistency appears when the motive for trading derivative

products is transformed from its original purpose of securing profits to generating profits,

with their use by so called ‗speculators‘ (Steinherr, 2000). As the profit generating motive

can be executed with immense leverage, this creates an attraction for profit generation that

uses these tools rather than profit securing which is mostly done by producers and consumers

in the real productive economy. Thirdly is the notion of fundamental asset value in the

financial markets which appears as the most contrasting inconsistency of all in the

institutional framework of financial markets. This section of this research focuses on the

concept of fundamental value to analyze certain theoretical explanations of financial market

instability because these explanations create fundamental asset value as their vantage point

for providing substantial reasoning for asset price bubbles or financial market crashes.

Fundamental value for any asset whether it be tangible or intangible is based on the

supply and demand concept that has been adopted from the production processes of the real

economy. This concept controls the prices that are initially based on inputs like labour, raw

material, invested capital, and expected revenue (Itoh and Lapavitsas, 1999). This only

includes palpable assets such as the production of heavy machinery or the manufacturing of

shoes that have a certain value attached to them. The capital invested has a purpose for return

on what is being produced and bought by consumers for certain usage. The end product

produced is introduced in the market with a value that reflects expected revenue that the

seller of the product expects on its sale in the market. However, the role of supply and

demand can change this expected value of the seller to a higher or a lower level depending on

the supply of the product and the demand that has been created in the market. Thus, the

market forces effectively play a crucial role in the price change for the product. Yet, there is a

point of reference that can be associated with the process of production and an expected

initial value or the fundamental value for the product can be marked.

28

For a financial asset like a stock or a bond or a future or an option, it is highly

complicated to estimate its initial value. This makes it impractical to fix a point of reference

that can associate a fundamental value for this asset. With the break in the late 1970s, where

the global economy which was till then mostly dependent on production processes, there can

be observed a transition into a global financial economy, where financialization of most

economies in the world led to the growth of strong financial sectors, with much larger overall

transactions of money and inflows of productive capital into the financing of liquid assets and

generating profits from such investments. This led to the shift of ideology of a fundamental

value for assets in the new formed global financial economy, which previously existed in the

productive economy. In the viewpoint presented above the prevailing idea of fundamental

value, has thus been adopted from the production economy, widely used by many theoretical

viewpoints to explain the overshooting of prices or crashing of stock markets from their peak

value (Itoh and Lapavitsas, 1999).

To shed more light on the contradictions that arrive with the notion of fundamental

value of assets in financial markets it is essential to discuss the creation of asset values in the

world of finance. The value creation lies in the consensus making tendency of the converging

market expectations for any financial market. Real assets in the productive economy are

valued on the basis input costs and revenue generation that is expected over the invested

capital in the process of production. For a financial asset the same mechanism cannot be

assumed as financial assets are not real assets that need inputs and require capital for

production. Most assets in financial markets are liquid in nature. For example interest rates,

currency exchange rates, and mortgage securities are all mostly intangible liquid assets that

do not have a clear and defined cost analysis that can identify a fundamental value for them.

These assets are traded on the financial markets with market forces determining their trade

value at any given point of time. Such assets have a trade value which can be highly variable

and volatile due to their quality of acute liquidity. Fundamental value for such assets is a very

relative concept mostly governed by the market expectation of the future levels of their price

or value, and any relative timeframe can provide a new fundamental value to such asset

prices. It is dependent on the theoretical viewpoint that analyzes this value, and within a

timeframe, it can attribute certain price levels as fundamentals to the prices of the financial

assets it engages with. This exposes the weakness of the asset price bubble theories in

explaining the price bubbles as their reference point is not made explicit in most cases.

29

Due to this undefined nature of the notion of fundamental value, the concept of

fundamental value for different asset classes discussed in the literature on financial markets,

especially futures markets, brings itself to a contradiction. When different theories on asset

price bubbles discuss the formation of these economic or financial bubbles, their basis of

explanation emerges from the idea of divergence of the financial asset prices from their

fundamental value (Sornette, 2003). This can define the role of a bubble that emerges within

an economy and its effects on the economic, political, social spheres of this economy, but the

starting point of bubble theories have a problematic nature. This problem has been outlined as

the notion of fundamental value based on which the analysis of speculation on future

expectations against some fixed reference of stable prices is performed. As market

participants follow their expectations of the certainty of price movements in either direction

against the current price levels, the fundamental value of any financial asset price becomes

dynamic with the changing expectations of the market.

Alternatively, if we look at the concept of fundamental value from the aspect of

underlying assets or underlying fundamentals, there is an important observation that can be

marked in the way participants of financial markets react to change brought by events in

these markets and pricing of financial assets following such events. To throw some light on

the critical aspect of asset price bubble formation we consider an investor willing to speculate

on the price movements of different financial assets. An investor forms future expectations

based on the information that is available at present, the historical averages on the price of the

particular asset, and the market expectation of the future price change for the asset (Bose,

1988). With this future expectation of certain change to the price of the particular asset the

investor considers the fundamentals to change and take a new value in the future. In order to

generate profits on the expected future price movements, the investor, or in this case a

speculator, would base their decisions of the current underlying fundamentals and of the

expected certainty of the fundamentals to change in the future on the market events and

circumstances. By description in most theories in the financial markets literature the

occurrence of these events and circumstances are considered to be mere convergence of the

market expectations and anticipation for future change within these markets. Therefore, if the

underlying fundamentals for most financial assets are also a convergence of the market

expectation, then these underlying fundamentals do not form a sufficient and concrete basis

for the conception of fundamental value of the asset prices that can be fixed as a point of

30

reference for the analysis of a bubble formation and its burst in the financial markets or the

economy as a whole.

For example we see a derivative tool like a „futures contract‟ on a stock, being traded

on the futures market, for the purpose of understanding the inadequacy of supplementing

underlying fundamentals as any substantial reference for measuring price variations or in case

of a bubble - price overshooting. Consider a scenario where a stock is being traded at a

certain spot price of and the futures contract on the stock is bought at a particular premium

value. A sudden shift in the market expectation for the stock can create significant

investments in this stock, as it is the nature of investors to push the price higher and higher by

investing in a rising price stock to gain profits by buying cheap and selling dear. In a short

period of time stock rises to a new price level where it becomes stable again with the

convergence of market participants expectations. In this way a dichotomy arises, questioning

the level which this stock price can be considered as the fundamental value for the stock

price. Both scenarios represent a stable state for the stock, within a given time frame, and the

underlying fundamentals in each case have a variable context due to market expectations

changing and converging at two different levels in two different times. Thus, for most

financial assets a change in the underlying fundamentals is only theoretical concept (Harmes,

2001). In practice, the creation of the market consensus in the financial markets and

convergence of its participant expectations form the basis for strong or weak underlying

fundamentals. If there is a sudden price change then a reference to one supporting underlying

fundamentals for a reference fundamental value of the asset price cannot be determined. The

change in underlying fundamentals become only a reflection of the changing market

consensus created by varied investor opinions over any given set of information that relates to

the asset. Therefore, these opinions can result in the change of the asset price to a new value,

which could be assumed to be fundamental within a certain time frame. Supporting this idea

is the analysis of Harmes (2001) who criticizes the idea of fundamentals as something static

that can be fixed as a point of reference for pricing of financial assets

“...Determining the correct price for a stock, bond, or currency is difficult because

it‟s part science and part art. It involves the science of researching what the

fundamentals are and the art of determining what they actually mean.

Determining what the fundamentals mean is difficult because it also involves guesses

about what could affect those fundamentals in the future. Two investors looking at the

31

same set of economic fundamentals may come up with very different ideas about what

the price of a particular asset should be” (Harmes, 2001)

Arguments are drawn to expose the problematic nature in understanding the

fundamental value of financial assets and its relationship with derivative. To focus on and

underline clearly the methodology of bubble formation suggested by the bubble theories and

hence a common bubble theory explanation based on the Minsky‘s (1986) financial bubble

analysis needs to described. A financial bubble is a condition of sharp appreciation of prices

of the assets being traded in a financial market. This is called a bubble as in theory and

practice the price appreciation does not account for any supplementing change in the

underlying fundamentals of these assets. A boom in the financial economy is attributed to

investor choices following the price change trends and the prime motive of buying low and

selling high for maximizing the profit margins that can be achieved by trading in these assets.

With a similar converging expectation of many investors within these financial markets can

create a self-fuelling cycle of a circular chain events that create further appreciation of prices

and thus there appears a sudden shift in the prices within a short period of time. When the

price starts raising continuously more investors want to become part of the profit making

community within these markets, the price pushes movements into a cyclical chain of

causation. This helps to inflate the bubble that begins to appear with rapidly appreciating

asset prices. This is accounted in Stanford‘s (2003) analysis of Minsky‘s bubble theory as the

‗herd behaviour‘. This describes most investors to follow the trend of investments that are

being pursued and formulating choices triggered by events that are already inflating the

market. If the markets were self-inflated then there would be a simple downfall in the value

of asset prices from their peak value, where investor opinions would start to diverge from any

further appreciation of asset prices, and the asset values would fall in the same cycle as they

had appreciated before. However, investments made in the financial economy do not

constitute a ‗zero sum‘ game because most asset valuations in the financial markets are

closely linked to the decisions that various economic agents like governments, corporations,

and individual investors make based on the apparent ‗paper wealth‘, as referred to by Jim

Stanford, that they have gained with the asset price appreciation.

‗Paper wealth‘ is a concept based on economic agents in a real economy who are

under an impression of an increased overall wealth due to gains that they have achieved in the

32

financial markets. These gains do not constitute any real wealth until the investments made in

the financial assets and the gains achieved have been created into liquid positions by selling

those assets in these financial markets. This phenomenon pushes for higher spending and

lower saving thus fuelling growth in the real economy, like corporate profits or GDP growth

in short-term. The increased growth leads to further appreciation of the financial assets and

the cyclical upward movement of the asset prices is sustained in short-term. Thus, the idea of

the bubble as underlined by Minsky‘s (1982) theory refers to the circular and self-

propagating build up of asset prices that create a wealth effect in the financial economy, as

well as, within the real economy and creates a condition of highly inflated asset prices,

named as a bubble in the financial markets and the real economy. The cyclical lending of the

banks also supports the idea of increased growth, higher spending occurs due to increased

bank lending and availability of liquidity in the market.

Harmes (2001) introduces a very critical idea of price overshooting which

corroborates the Stanford‘s (2003) wealth effect and Minsky‘s (1986) bubble theory analysis

by providing an explanation known as a ‗positive feedback‘(Sornette, 2003) in financial

literature. Returning to the original argument that most investors, contrary to the neo-classical

view point, are not perfectly informed individuals making rational choices about their

investments in the financial markets but rather follow the trends that are visible and rely on

most recent information to base their decisions in creating future expectations in the financial

markets. With any small movements in the asset prices, based on any false signals, causes the

investors to make poor decisions over the asset price rise and, by the same nature of

maximizing profit, margins investors push the asset prices further up by buying these tradable

financial assets at increasing prices. This leads the markets to shoot in a positive or upward

direction, bringing about the impression of ‗paper wealth‘ as discussed earlier. This creates

the same cycles of increased spending, lower savings, increased bank lending resulting in

more liquidity in the markets, and therefore, higher levels of debt. When the markets correct

themselves the prices can overshoot in the negative direction creating strong imperatives for

the economic agents as the ‗paper wealth‘ trickles down leaving behind greater amounts of

debt than what can be repaid, much lower savings and low level of liquidity in the market as

bank lending runs out due to a crisis of confidence also imposes the burden of increased debt

for governments, corporations, and households. Similar logic can be applied to most financial

assets, like currencies, stocks, bonds, and securities. The concept of price overshooting

emphasizes the importance of the inconsistencies relating to financial markets that were

33

outlined before. Most importantly, fundamental value of assets upon which the bubble theory

explanation rest the notion of price movements, cyclical self-fuelling price overshooting, or

other such concepts like ‗paper wealth‘ will be considered in detail in respect with derivatives

markets to see how the link between fundamental value and financial bubbles creates no

direct correlation and thus a contradictory argument can be drawn against the foundations of

these bubble theory analyses.

With reference to the working of a derivative market as discussed in the last chapter

on derivative theory and trading, we will go a step forward to examine the details of how

derivatives can create a bubble as they are mostly criticized for creating volatility in financial

markets and unstable financial asset prices by providing speculators with a leverage to take

on the financial risk for high returns which could generate huge profits or result in equally

high losses. Many theorists like Brian and Rafferty (2006) argue that price formation of from

an asset‘s value takes place in the futures market based on which the spot market prices are

formed. Thus, derivative markets according to this argument play a very important role in the

price formation and hence price movements for financial assets. Derivative markets, by

theory, serve to redistribute the risk through formal contracts where two different investors

can have a different perspective on risk (Sunni, 2006). One is committed to divest the risk

and the other is willing to buy that risk due to contrary future expectations of price

movements. This relationship returns to the important link of derivatives trading to the

creation of financial bubbles is the pricing of risk. If the investors are willing to take more

risk, the prices of assets are pushed up in the futures market and the same is reflected in the

spot price of these assets. When the futures are sold at a premium to the spot price, then the

dominant market opinion reflects the future expectation of a possible price rise in the spot

market for the same asset. Yet, the notion of a bubble within a financial market is in reference

to certain fundamental price levels above which the price has been overshooting to

appreciated levels. For derivatives the asset prices have no particular importance as they have

been established to reallocate risk that is associated only with a price change for these assets.

Derivatives encompass the risk of volatility in prices, and therefore, derivative trading is in

essence the trading of risk or volatility. Therefore, this research argues that for a derivatives

market, fundamental value is of no significance even in the instance of an existing

mechanism to arrive at a fundamental value of any particular asset being traded on the

financial markets.

34

In the creation of a financial bubble, derivatives can be understood as drivers of the

price movements that initiate the cyclical price appreciation. This can result in the inflation of

prices on the spot and futures markets, as a consequence of such price changes. Speculators

create market positions against the producers or consumers, who are willing to secure their

profits by locking in a certain price in the present for a future transaction without real

ownership of any asset or commodity in the present through the use of derivative tools like

options. Speculators bear the risk that has been channelled to them that was initially borne by

the producers and consumers. Speculators are assumed to base their investments on

underlying fundamentals even if the price movements are against the expected returns in the

short-term. This is due to the investments based on underlying fundamentals speculators

profit in the long-run (Steinherr, 2000). These underlying fundamentals are the basis of the

price formation for a fundamental value with the perception of the speculators. This implies

that the underlying fundamentals create the fundamental value that comes under

consideration for the purpose of profit securing or profit generation. However, when the

concept of derivative trading is abstracted from principal asset prices and is only involved

with the volatility of prices, the underlying fundamentals are variable with change. In this

way, there is no specific fixed reference value that can be associated with the financial asset

prices.

3.3 Financial Instability, Role of Derivatives, and the Concept of Value

It is reiterated that the adoption of fundamental value from the production economy has

entered into the financial economy as an abstract concept which cannot be made the basis for

putting forward a theory with fixed references to values. This is because these values are

variable in nature and are mostly formed in the mind of the investors that analyze any given

set of information within a specific time frame. If presumed true, this contradiction brings

into question the definition of ‗real economic fundamentals‘ (Toporowski, 1993).

Underlying fundamentals could be understood as qualitative standards with which different

investors perceive different expectations of price movement due to many viewpoints on the

risk associated with any event within these markets. It is for this reason that investors buy

risk while simultaneously there are others selling the same risk in the financial markets. If

there was a certain view towards underlying fundamentals or a particular value associated as

the fundamental value, then all investors would engage in a similar pattern of trading. This

35

would result in an impractical scenario where there would either be just buyers or just sellers

of the derivative products, or in other words any risk would have only buyers or only sellers.

This is not the purpose of the derivative markets and its innovative tools that allow the

capture and control/redistribute the risk within financial markets. Hence, in the asset price

bubble theories the concept of price overshooting or asset price amplification has a relative

reference to the levels within a particular time frame. However, to generalize these theories to

broader periods in the history it is useful to clearly define the concept of fundamental value

that is assumed by the particular theory.

The problem with bubble theories does not lie in the explanation of formation of

financial or economic bubbles, but it is problematic due to the assumption of asset price

appreciation at a certain point in time. If financial asset prices start appreciating and reach a

certain level and then in the future the same prices still appreciate to a further higher level,

where is the point of reference for the origination of the bubble? This is inherent to the

explanations of the bubble theories where there is no relevance to the idea of origination of

the bubble as it merely comes to a market convergence—possibly resulting in a consensus

building towards the socially constructed reality of a bubble existing in the financial markets

or the real economy.

In order to generalize the various ideas that have been discussed for bringing out the

problematic nature of the concept of fundamental value we consider the above explanation of

the formation financial bubbles. The clear problem that the assumption of fundamental value

brings with it is the idea that a financial bubble resulting out of continuously inflating

financial market is always relative to an undefined fundamental level of the asset prices in

that market and it is not possible for each investor to clearly and precisely constitute asset

price valuations based on certain fixed fundamentals. This helps explain the ‗herd behaviour‘

by supporting the contradiction that fundamental value of asset prices remains undefined.

Therefore, asset price appreciations will be perceived differently by different investors within

different time frames. Thus, investors investing in certain assets at lower prices would view

that as the profitable level with more appreciation. However, for another investor entering

into the market with a late investment on the same asset would still be hopeful with the same

optimism as the first investor, but within different time frames.

This brings about three basic arguments against the fundamental value assumption: 1)

markets are inherently volatile, 2) investors are not rational subjects with rationality of the

36

market being the rational whole of the individual subjects, 3) and price overshooting is a

relative concept in the financial markets. First the financial markets that are subject to risk

management tools like financial derivatives are inherently volatile because the role of

derivatives is based on volatility in the markets without which the risk management tools

becomes redundant. These markets have stability at different levels at different points of

time, and therefore, the idea of fundamental value for the asset prices does not play a role.

Hence, there is no fixed point of reference for asset price values. Secondly, for the

fundamental value to be defined in the financial markets, the investor opinions have to

constitute a rational choice convergence of the expectations for asset prices. As previously

discussed, in the reality or practice of the financial markets, this cannot be the case due to

investors being partially informed and being most affected by the most recent available

information and events. The rational choice idea of subjective rationality is not justified in the

case of financial markets as most investors are influenced by the overarching market trends

and present circumstances. This is supported by Shriller‘s (2005) ‗herd behaviour‘ theory

explaining investor psychology in financial markets The theory outlines that investor‘s

rationality for future expectations is based on the overarching rationality created by events

and circumstances within the market. Thirdly, price overshooting can be attributed to most

convincing explanation of the asset price bubbles and its formation but the roosts of this

concept lie in relative terms to asset prices within a given time frame. The fundamentals are

dynamic in nature and to fix them to a certain value requires a reference time frame for which

the theory can becomes a complete explanation to throw light on financial instability and

market crashes due to financial and economic bubble bursts.

Establishing that fundamental value is a problematic in nature to define and to realize

its existence in financial markets we can focus on the factor that attributes financial

derivatives a new dimension for future analysis. Volatility is inherent to financial markets and

derivatives are as important as they are destructive in nature to these financial markets. So,

there is a clear indication that financial instability has to be experienced in research within a

framework of financial derivatives as they exist. Criticism of financial innovations through

their impacts on bubble formations or price upsets is only limited to the abstracted level of

understanding of financial management tools. There is a need to move beyond this

abstraction and put efforts understand the existence of such destructive financial mechanism

of risk control within the institutional framework of financial markets and the financial

economies as a whole (Bryan and Rafferty, 2007). The next section would introduce the

37

notions of financial fragility in market economies with focus on certain cases of extreme

financial instability. In order to delve into the role of derivatives and to understand that this

role has become essential even when it creates weakness in the overall financial systems and

to question the financial risk management tools for the purpose of their existence.

4

Transition in forms of Financial Instability and the Criticism of Financial Derivatives

Financial Fragility is the concept of self-fueling financial asset bubbles which are self-

fulfilling and with intangible factors like investor mood swings these bubbles can bust

creating dramatic consequences for financial markets, which spill over to the real economy

which depend on these markets.

“The boom and bust process can occur independently of the underlying economic

fundamentals of the particular companies involved, yet ironically the cycle can have

important effects that extend beyond the paper economy to the real investment of the

real capital and the real production of goods and services. The financial ups and

downs are entangled in a complex, dynamic web of relationships between asset prices

(like stock and bond prices), interest rates, and the subjective confidence of company

managers and consumers in the real economy. Economic growth itself becomes

subject to the whims of the market.” (Stanford, 1999)

In other words, with an initial asset price rise, weather based on real fundamentals or

subjective expectations, the investors will buy assets to make profit by selling them in the

future at a higher price. But these expectations of future profits are not always serviced by the

financial markets. It would be too simplistic to discuss financial economy‘s rise and fall

which affects asset prices with a concentration on just the financial institutional framework.

In reality, it is a complex relationship between real economy where real goods are produced

and real investment takes place and the financial market where these asset prices are subject

to volatility and speculation. This complex relationship forms actor expectations in the

financial markets, which in some explanations is based on economic fundamentals, but

overvaluation of assets in a financial market are responsible to create the bubble effects

within the real economy and its constituents, thus creating drastic consequences which reach

38

further beyond the financial arena into the real economy, especially when actor expectations

diverge and not correspond to the financial markets trends.

4.1 Transition of Financial Derivatives with Financial Crises

For an analysis of the role of derivatives in the Asian crises, there are a lot of factors that

created a combined effect for the crisis outbreak during the late 1990s. East Asian economies

had huge inflows of foreign capital into their financial markets and real asset investments

(Foreign Direct Investments) (Dodd, 2002). This foreign capital was under the risk of local

currency dependence and a risk of depreciation pushed these financial flows to be hedged

against possible local currency depreciation. For the purpose of hedging against this risk,

various derivative tools like forwards and swaps were used. Using a forward contract the

securities or other assets denominated in the local currency the foreign investors could be

hedged against a possible depreciation in the financial asset value following the local

currency depreciation. Similarly, there were many swap options that were used to restructure

the transaction where the floating interest rates could be changed to fixed interest rates,

currency denominations could be changed, and payments could be moved into different

periods so as to avoid tax on income and earnings and likewise a lot of risk exposure could be

removed off the balance sheets (Steinherr, 2000). Swaps were a major source of credit losses

incurred during the Asian crises where most defaults appeared on the forward contract swaps.

Apart from the regular hedging strategy that was used to minimize the risk exposure

associated with being invested in the assets denominated in a foreign currency, there was a lot

of speculation on the currency movements using the same derivative instruments.

Derivatives, as discussed in the previous chapters, provide a greater leverage and lower

transaction costs as there is no real exchange of any asset or commodities but only a price

change that relates to the derivative investments. These were a major channel for investors,

often referred to as speculators or currency attackers, to create positions against the stability

of fixed exchange rates (Dodd, 2002). Use of derivatives created the lowering of the cost of

investing against the fixed exchange rates, and therefore, only further encouraged such

investor behaviour in the developing economies of East Asia during the late 1990s. If we

relate this speculative nature of capital investment in the financial markets to the concept of a

fundamental value, then there is a small room under which these speculative positions in

financial markets against the fixed exchange rates could be justified based on some future

39

expectation of weak underlying fundamentals. Most of the speculation was due to readily

available tools that had lower capital costs to create such positions in the financial markets

for generating profits as market expectation was converging and most investors were

following the trends to create a consensus of weakening of the local currencies within these

East Asian economies. The influx of foreign capital within these economies was a constraint

for the central banks to maintain fixed exchange rates and the speculators were betting

against the capacity of the central monetary authority to maintain fixed peg for local currency

for an indefinite time period. Carry trade was another offshoot of the availability of derivative

tools that could be used in a fixed exchange rate system for generating profits on interest rate

differentials (Hartmann, 1998). Borrowing at lower interest rates in the local currencies of the

Asian economies and selling at a higher interest rate in the other currencies was becoming a

common trend. The carry trade was profitable for the banks in the developing economies in

Asia but resulted in the solvency of these financial instructions due to the exchange rates

falling below the interest rate differential. All these factors and more were responsible for the

Asian crisis and the prime role of derivatives in making the crisis into its exaggerated form is

evident by the above explanation. It can be clearly observed that if there was anything

fundamental to the financial bubble that was created in these economies it was the volatility

that was captured by derivative instruments and redelivered into the market with further rise

in this volatility.

The subprime crisis that originated in the year 2007 in the US economy was a result

of another form of securitized blunder that the financial economy can create within the

financial and the real economy. Subprime loans are the high-interest driven mortgage lending

due to their high default rate, as most subprime loans are not backed by collateral. With the

extraordinary abstraction that can be created with the use of derivatives these subprime loans

or mortgages could be transformed into tradable securities (Blackburn, 2008) that were being

traded in secondary markets to generate debt finance. These securities ran into chains of

securitization (Pollin, 2008) and were not a clear reflection of the risk exposure they had with

the originating event.

These derivative securities have been traded across different financial markets due to

an increased standardization of the financial markets. So, the risk associated with the

innovative forms of derivatives that are being traded today as compared their past forms are

much more complex and have distributed high risk exposure to the other financial assets with

the formation of linkages among various asset classes. Mortgage backed securities which are

40

used to raise capital in the secondary markets have surpassed the capital generated by US

treasury bills since the year 2001 (Dodd, 2005). This clearly indicates the prominence that

can be ascertained in the derivatives trading that exists today compared to its primitive forms.

In contemporary period of financial markets, and derivative trading in particular, the risk has

manifested itself in much deeper forms penetrating into the society and creating broader

imperatives and serious social, political, and economic implications in case of financial

instability. Like the very large scale securitization and trading of mortgages in the secondary

markets creates systemic risks for the economy as a whole, as it interlocks real investments

with highly liquid and high risk oriented financial assets. This has led to higher volatility and

increased instability within the financial markets through the wide use of these newly formed

streams of finance and their risk management through the use of derivatives.

There is no fundamental reason to argue against the drastic role of derivatives but at

the same time the imperatives of the current global economy make these tools indispensible

as their materialization has been propagated through conscious efforts of innovating risk

management (Bernstein, 1998). With each financial innovation unearthing a new form of

risk, risk management in itself has become the source of future risk in market economies.

Underlying fundamentals or fundamental value of asset prices cannot be argued as a concept

based on any practical or theoretical existence because of the thick network of interlinked

assets that has been created by the rapid developments in securitization of various new forms

of asset classes. This highly integrated network of interlocked values for assets has led to the

diminishing of clear definitions of underlying fundamentals or fundamental value for

financial assets along with the increased source of risk and volatility in the financial markets.

Theoretically derivatives still conform to the logic of controlling the increasing risk in the

financial economy but in practice the role of derivatives can be viewed as a flourishing

scheme to create newer forms of financial assets that can be traded and bet on for creating

value in price change or volatility, thus inducing more instability in the financial markets.

The comparison for two crises, one in the developing economies in East Asian in the

late 1990s and the other in the US in 2007 that was considered the world‘s most strong

economy, indicates a structural change that has been brought into the financial markets and

the increasing span of available financial assets that can be traded on these markets. An

observation made in the use of more sophisticated and complex networks created by the

system of derivatives in the current global economy is that all financial innovations have had

serious consequences for even the developed economies. The distinction of weakness based

41

on developed and emerging markets has been blurring due to the vast exposure of derivative

products that can create instability in any economy whether be developed or developing by

creating systemic risks for maintaining the streams of financial liquidity in times of

instability, that can be caused with a trigger like the subprime defaults in the case of US

financial markets in 2007. The risk has been effectively distributed for affecting the closely

integrated and coupled financial economies of the world, and it is evident by the large losses

incurred by investors in major financial markets of the world, whether be in developed or

developing economies. To pass a judgement that this new formed face of derivative trading is

a boon or boom for the global financial stability is still difficult, because to choose one stand

seems to contract and undermine the horizon of understanding of the contemporary financial

markets. But there is a definite increase in the overall risk that is posed by the ever complex

derivative instruments. The innovation in derivative markets have brought a structural change

to the global financial economy which now has much deeper direct linkages with the real

economy, on the production and consumption and on the decision making processes, that

create real investments and developments for economic growth for various economies in the

world.

Conclusion

The occurrence of derivatives and its widespread use in the financial economy has been

considered as a natural existence that has no relation to the events and circumstances under

which they have appeared and evolved in history. This line of argument undermines the role

of real economy and the imperatives of transition and the developed role of the financial

economy of the world. The analysis in this paper examines the period of late 1960s and 1970s

as the period of transition from the dependence on real productive economy to the more

influential growth in financial economy. Based on this analysis the paper argues that origin

and growth of derivatives have its roots deep into the real economy and the circumstances

which led to rapidly occurring periods of volatility and thus produced the need for creation

and development of tools that could mitigate this risk and hedge the profits of producers and

consumers that were badly affected by problems of inflation, currency exchange rate

fluctuations, sudden commodity price hikes, and many similar factors. The basic outline that

this argument creates is that financial derivates have been a conscious response of the agents

in the real economy for the conditions that prevailed and have been dominant since the late

42

1970s in the financial economy and has its clear implications on the economic stability of

various market economies.

The risk that is captured by the use of derivatives is a socially constructed

phenomenon, as according to the analysis of Beck (1999) risk has always prevailed but it is in

the nature of modern society to identify and extract the uncertainty of future events and

attempt to control the risk associated with this uncertainty. If this nature of modern society is

analysed for the financial economy, its rapid growth and developments of new forms of

financial flows produced conditions that created a need to innovate new forms of financial

risk management appearing as financial derivatives. The continuous production of new

derivative tools has manifested itself in the financial economy with a contradiction of their

existence in theory and practice. With this deconstruction we can clearly observe that, in

theory, derivatives have the role of managing risk by shifting the risk from more risk averse

participants of financial markets to those who are willing to take on more risk with the desire

of maximizing profits. This redistribution of risk has different interpretations in different

theories but the distinction that has been widely discussed in the literature is the contradiction

appearing due to the ideological separation of ‗profit-securing‘ and ‗profit-generating‘ using

financial derivatives in futures markets. Speculation on financial asset prices is directly

associated as one of the major use of derivative tools and the advantage to pursue such

speculative activity with the leverage they provide for creating high risk exposure with small

capital involvement.

If we try to understand the basis of how derivatives work on the financial markets

then this contradiction appears to fade as the theoretical reasoning of derivatives to stabilize

the volatility inherent to financial markets and the capturing of risk and mitigating it for

stability of prices weakens substantially. Derivatives work on price change, or volatility of

financial asset prices. If the start point of derivatives and their only acknowledgement of

existence is the volatility of prices then to argue against the volatility that derivatives induce

in the market holds small significance. It also counters the theoretical distinction between the

so called – ‗hedgers‘ and ‗speculators‘ as all participants in this market are willing to use the

same tools that can create profits or secure a certain value, in the future. The most

fundamental aspect to derivatives is their role of risk reconfiguration. Derivatives are made to

capture risk and redistribute it among investors in the market but at the same time they spread

the risk of price change to a much wider span affecting the profits of different market

participants at the same time. This nature of derivatives creates a risk for the wider society

43

and has implications which move beyond the realm of financial economy into the real

economy, the social conditions, and the political framework of the economies as a whole

(Bryan and Rafferty, 2006). Bryan and Rafferty (2006) present a very important and unique

outlook to the analysis of derivatives stating that system of derivatives create a mesh or

network of interlinked asset prices by creating linkages among different asset classes. This

has been possible because derivatives are not directly based the underlying asset or

commodity but only on the price change of that asset. With much innovation during the last

three decades in financial derivatives the new complex forms of derivatives are creating

cross-linkages among different asset price change through instruments like swaps. Swaps

provide the capacity to exchange the risk of one asset class with another without actual

ownership of any assets with the investors. Such innovations have created strong imperatives

for the financial economy as well as the real economy with interdependency of different asset

price changes. Instability in one class of assets can produce a widespread affect on the

stability of other assets and thus have become capable of creating much more complex

manifestations of risk in the financial economy.

The arguments on derivatives and the understanding of changes and developments in

the financial economy raise doubts on the nature of value of assets within the financial

economy. A value is important for an asset class until it is separated from external agents that

do not significantly impact its prices. But in a complex network of derivatives this is highly

unrealistic and observing the condition of volatility in the financial markets the notion of

fundamental value losses its importance. But if we analyse the nature of explanations offered

by asset price bubble theories (Minsky, 1986) then we arrive at a contradiction with the basis

on which these explanations are presented. Using the model of bubble theory presented by

Stanford (1999) this paper underlines the weakness of such theories as the lack in providing a

timeframe to argue for the bubble formations based on fundamental value of assets. The

problematic issue is the notion of sudden price appreciation that is based on the concept of

underlying fundamentals and the unrealistic appreciations of financial asset prices which are

not based on the underlying fundamentals that govern the price valuation for these assets.

Fundamental value, if at all of any significance, is dynamic in nature as contrary to a static

reference point based on underlying fundamental and this cannot be basis for the investors to

make choices because it is formed out of a market opinion convergence. This market

convergence has been argued to be a mix of opinions of different investors on the same set of

information, events, and circumstances that form investor choices which cannot be

44

considered fully rational and, therefore, do not form any basis for the importance of

underlying fundamentals in case of price appreciations. Harmes (2001) examines underlying

fundamentals as problematic as the concept of fundamental value because to clearly

determine the underlying fundamentals of any asset it is necessary to define the fundamentals

for that particular asset. With different investor opinions underlying fundamentals become

only a qualitative factor that have no significance but only reflections of overarching market

opinions about various financial asset prices.

So, the underlined problematic nature of fundamental value in some ways weakens

the basis of asset price bubble theories, and thus the concepts of price-overshooting (Harmes,

2001) and positive feedback (Sornette, 2003) create a contradictory appearance in their own

explanations while stating important factors of financial instability. Alternatively, financial

instability as observed with the role of derivatives is effectively based on price change as

derivatives have little relation to the principal asset prices and only work on the price change

for these assets. Returning to the role of derivatives as stated earlier, the dichotomy is clear

that derivatives are drivers of the volatility where at the same time their purpose is to control

the volatility that is associated with the asset price change. Even in this argument the role of

the asset price in themselves play little role and only price change for these assets is of most

significance which in turn undermines the role of fundamental value in explaining financial

instability.

With the decreased significance of fundamental value as a concept and the role of

derivatives as drivers of change in value the understanding of financial insatiability or

financial fragility comes to various interpretations. It is inherent in the nature and working of

financial markets to be volatile. Cases of financial instability have to be clearly identified and

analysed with individuality because the role of derivatives is very important to explain certain

implications on the instability, but simultaneously the form of derivatives and their nature of

trading has been under transition since their use with rapid financial growth. The financial

crises that have been observed in history have had different impacts and implication of the

use of financial derivatives in the formation of the bubbles and their bust. The shift in the

nature of trading of derivatives can be observed through this analysis and it indicates the

growing control and firm grip that derivatives are making with their ever complex forms. As

articulated by Bryan and Rafferty (2006) the role of derivatives have to be observed in the

full framework of an economy with social, political, and definitely economic implications.

The more influential role that complex derivative forms have played in each case of financial

45

instability since the East Asian financial crisis has unarguably created wider implications as

more and more developments are observed in the derivative markets. But the alternative view

to this argument calls for a different perspective in which financial crises should be analysed

as the complex forms of derivatives have entered into the social and political setup of

economies through the innovative financial derivatives like mortgage securities, etc. A

comparative analysis of different crises can only offer a partial view of the role of derivatives

in the contemporary financial economy. For a more comprehensive understanding of

financial derivatives today they have to be analysed in a much broader sense and their role

has to be separated from just labelling them as providers of volatility in financial markets.

This view point indicates towards regulation and policy which can come to secure some

aspects that severely damage the financial stability of an economy. There has to be a more

clear and focused debate on the role of derivatives and a new understanding of their existence

in the wider forms of society to gain knowledge on their continuous development and further

complexity even in the face of their drastic effects.

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