The advent of computerized option pricing models and standardized option contracts in the early 1970's led to the development and growth of a variety of option and futures contracts on U.S. government securities, stock indices, and currencies in the 1980's. The evolution of structured derivative products continues in the 1990's, ranging from exchange-listed instruments which offer retail investors opportunities once only available to investment professionals to private over-the-counter contracts that cater to the specific needs of institutional and high net-worth investors. The types of structured products and available payoff profiles range from principal preservation to speculation.
In recent years, structured derivative financial products have been the source of a great deal of controversy among government regulators, politicians, the media, the public and corporations. Derivatives are blamed for a number of financial problems, such as an increase in global stock market volatility, the financial collapse of certain U.S. municipalities and for large financial losses suffered by market professionals who have claim ignorance about the kinds of derivative instruments they buy and obligations they incur. Many investors, members of the public, financial market professionals and political leaders presume that it is only a matter of time before derivatives cause the meltdown of the world's financial markets, where one institution after another fails from the uncontrollable unwinding of a daisy chain of derivative-based transactions.
It appears, however, that derivatives are often the scapegoat for a number of more fundamental financial missteps. The following are a few of the more notorious business misfortunes that have been blamed on derivatives:
The Collapse of Barings Bank: The collapse of Barings Bank appears to have occurred through a combination of unauthorized activities of a rouge trader in Singapore, lax regulatory and compliance oversight and inadequate operational controls.
The Bankruptcy of Orange County: The U.S. municipality of Orange County, California, among others, provided a very high level of public service for a number of years despite the steady decline in California property values and related tax revenues. Taxes in Orange County remained low for years, due, in large part, from above average returns the County received from very risky interest rate derivatives it purchased with taxpayer funds. Orange County's appointed financial managers bet aggressively on the direction of interest rates. Unfortunately, after years of winning with derivatives, interest rates abruptly reversed direction in early 1994 (due to interest rate cuts by the U.S. Federal Reserve) and the County ended up losing over $1.7 billion. Orange County's treasurer, instead of acknowledging his incomplete awareness of the risks inherent in the types of highly speculative financial obligations he had incurred on behalf of the County, blamed "derivatives" for the financial crisis and the Wall Street dealers who sold them.
Financial Losses at a number of U.S. Blue Chip Corporations: Several blue chip corporations (e.g. Proctor & Gamble, who has raised a number of legal concerns about the structured derivative products it has purchased from Bankers Trust, as has Gibson Greetings Company) have used structured derivative products regularly as an efficient means of protecting their global business revenues from, among other things, currency and interest rate risk. Financial problems in such industrial corporations appear to arise, however, when managers and corporate treasurers, in search of profits, move beyond their risk management capabilities into speculative trading activities often involving a variety of complex derivative instruments and structured financial products.
Of course, dealers are not without fault. The concerns expressed by regulators and politicians about how various derivative instruments are marketed to investors, risk and financial disclosure, customer suitability and capital adequacy, among others, have a great deal of merit. It is important, however, to recognize that derivatives and the structured financial products created from them appear to have contributed to the global financial markets becoming more efficient. There are those who argue that "...a broad consensus [exists], both in the public and private sectors, that derivatives provide numerous and substantial benefits..." * It is unlikely, however, that a favorable consensus of opinion on derivative securities will emerge until more broadly identifiable benefits are realized from them.
Structured products and the derivative securities engineered into them, because of the financial leverage they often employ, can be highly sensitive to market valuation changes. They often act like the leading edge or "finger tips" of world financial markets, providing valuable pricing information about many types of financial assets, often before the underlying cash markets respond. They can provide investors with the first hints of market moves and valuable pricing information about the interrelationships of various financial assets trading in global markets. They can alert investors to international market behavior, facilitate the movement of risk exposure into and out of investment portfolios and allow risk to be shifted efficiently from investors who want it to those who do not. Investors who might avoid or liquidate certain investments because of risk concerns may use derivative securities and the structured financial products made from them to implement specific strategies, often without transaction costs, tax obligations and without selling the underlying assets. Structured derivative products can also be used by corporations to raise capital at lower funding costs. Despite widespread misperceptions about the nature, use, and applications of derivative instruments, "the ingenuity of the financial markets has transformed the patterns of volatility in the modern age into risks that are far more manageable...than would have been the case under any other conditions." **
The central goal of this book is to advance the development of a favorable consensus of opinion on derivative securities so that needed improvements occur in how they are structured, sold, and regulated, and so that their benefits to the world financial markets become more clearly known to broader segments of the national and international investment community and public at large.
** Peter L. Bernstein, Against the Gods: The Remarkable Story of Risk (New York, Wiley, 1996), p. 323.