Role of Derivatives in Global Economy - Study by CME and Milken Group

Derivatives – are good for economy argues Apanard (Penny) Prabha, Keith Savard  and Heather Wickramarachi in a study published by Milken institute.  In this study have analyzed and quantified derivatives impact and concluded,

http://www.cmegroup.com/education/growth-through-risk-management.html

“KEY FINDINGS

»≫Banks’ use of derivatives, by permitting greater extension of credit to the private sector, increased U.S. quarterly real GDP by about $2.7 billion each quarter from Q1 2003 to Q3 2012.

»≫Derivatives use by non-financial firms increased U.S. quarterly real GDP by about $1 billion during the same period by improving their ability to undertake capital investments.

»≫Combined, derivatives expanded U.S. real GDP by about $3.7 billion each quarter. The total increase in economic activity was 1.1 percent ($149.5 billion) between 2003 and 2012.

»≫By the end of 2012, employment had been boosted by 530,400 (0.6 percent) and industrial production 2.1 percent.”

Derivatives are termed as Financial WMD by famed investor Warren Buffet. In the wake of great financial crisis of 2008 regulators have focused on bringing transparency to Derivatives trading blaming some of these products do not provide any value to the society. This study first of its kind in terms of not only putting together case studies on how Air line carriers hedge their oil cost by using Oil based derivatives, Food processor hedging his production costs by utilizing grain based contracts and most importantly how banks are able to intermediate loans by managing their interest rate risk but also building a quantitative model to back their analysis.

“WHY USE DERIVATIVES?

Investors generally use derivatives for three purposes: risk management, price discovery, and reduction of transaction costs. In a traditional banking model, a maturity mismatch between assets and liabilities subjects banks to interest rate risk. Derivatives mitigate this risk, which often contributes to capital adequacy, profitability, and lowering the probability of bank failure. In addition, banks make markets in derivatives to meet the risk management needs of financial and non-financial firm customers. In the process, they generate fees and other revenue from this trading as well as lower their cost of funding.

Derivatives Help Price discovery

The information that can be extracted from derivatives, such as price discovery, is another important benefit. In “complete” markets (when agents can buy insurance contracts to protect against any future state of the world), trading on derivative exchanges should reveal no new information to market participants. However, the lack of completeness means that informed traders could prefer to own futures or options in lieu of the underlying assets, and this might reveal new information about price. Most studies done on developed nations show that the futures market leads the spot market and therefore serves as the focal point for price discovery.”

I totally agree on all three points that derivatives, are helping in risk management, price discovery and reduction of transaction costs. For instance, when we consider housing market where a typical home buyer goes out to take a 30y fixed rate loan from his bank. Bank hedges this loan on its books with various interest rate derivatives (swaps) to risk manage the interest rate risk. In doing so they transact swaps leading to activity in the swap market and price discovery and leading to better rates to the home buyer.

Authors have chronicled the history of Derivatives in terms of when they started to current day regulatory environment. Growth in the trading volumes of derivative products clearly coincided with increase on global trade and rise in both bond and Equity markets.

“Given the expansion of international trade and financial activities, participants are likely to face increasing risks, and derivatives markets are expected to contribute to economic development by making these risks manageable.”

Interesting fact here to see how big Derivative markets are when compared to global GDP.

After looking at the Trading volumes focus has moved to how this growth has benefited overall economy within the framework of Risk, Price and Cost factors.

Banks use derivatives predominantly to manage the risk arising due to their banking and trading operations. Below chart shows how banks have started increasing using the derivatives on their books. Most of this derivative activity is concentrated in the hands of few large banks. As OCC’s quarterly report confirms, four big banks, JP morgan, Bank of America, Citi bank and Goldman Sachs have had lion’s share of the market.

For nonfinancial Firms Derivative have been serving purely for hedging purposes.

Below chart shows how derivatives have saved some of these firms big money.

This chart provides details of how various users of the Derivative market come together for their needs and consequently affecting the economy. Interestingly, nonfinancial firms are able to increase their firm value by using these products to hedge cash flow volatility.

Banks that use derivatives to manage their operations are able to increase their loans. Below another chart that shows this positive relationship between loan growth and Derivatives usage.

Authors have studied above relationships and confirmed usage of Derivatives is benefiting the Real GDP and increase in employment.