Question

 

“The role of derivatives markets have been reassessed since the 2007 Great Financial Crisis (GFC)”. Discuss the following in view of this.

(a) [35 Marks] Stock market index futures help to hedge against market risk. However, there are limits to arbitrage that might reduce the effectiveness of this strategy.

(b) [15 Marks] Discuss how the $700 trillion derivatives markets have contributed to the moral hazard problem called “too interconnected to fail” which required an extensive tax payer bail out during the 2007 GFC.

Answer 1

a) Introduction: The textbook definition of “arbitrage” involves a costless investment that generates riskless profits, by taking advantage of differental pricing across different instruments representing the same security. Arbitrage is critical to the working of efficient markets, since it is through the arbitrage process that fundamental values are kept aligned with market prices. In practice, arbitrage include costs as well as the assumption of risk, and for these reasons there are limits to the effectiveness of arbitrage in eliminating certain security mispricings. This is ample evidence that might lead to failure of hedging strategies.

Even though Arbitrage provides for Hedge against market risk in the future market there are certain limitation to it which are as follows:

Fundamental Risk. we may identify a mispricing of a security that does not have a close substitute that enables riskless arbitrage. If a piece of bad news affects the substitute security involved in hedging, we may be subject to unanticipated losses.it may lead to loss making situation for hedging positions.

Noise Trader Risk. Noise traders limit arbitrage. Once a position is taken, noise traders may drive prices farther from fundamental value, and the arbitrageur may be forced to invest additional capital, which may not be available, forcing an early liquidation of the position. hence failure of risk minimization strategy.

Implementation Costs. Short selling is often used in the arbitrage process, although it can be expensive due to the “short rebate,” representing the costs to borrow the stock to be sold short. In some cases, such borrowing costs may exceed potential profits. If short rebate fees are 10% or 20%, then arbitrage profits must exceed these costs to achieve profitability.

Apart form limitation to Arbitrage hedging in itself have some attributes which may turn out to be of some trouble like:

• Hedging involves cost that can eat up the profit.
• Risk and reward are often proportional to one other; thus reducing risk means reducing profits.
• For most short-term traders, e.g.: for a day trader, hedging is a difficult strategy to follow.
• If the market is performing well or moving sidewise, then hedging offer little benefits.
• Trading of options or futures often demand higher account requirements like more capital or balance.
• Hedging is a precise trading strategy and successful hedging requires good trading skills and experience.

b) The real cause of the Great financial crisis was the proliferation of unregulated derivatives in the last ten years. Derivatives are complicated financial products that derive their value by reference to an underlying asset or index. A good example of a derivative is a mortgage-backed security

How Derivatives Worked to lead to crisis

Most derivatives start with a real asset. Here's how they work, using a mortgage-backed security as an example.

• A bank lends money to a homebuyer.
• The bank then sells the mortgage toFederal National Mortgage Association(Fannie Mae).This gives the bank more funds to make new loans.
• Fannie Mae resells the mortgage in a package of other mortgages on the secondary market. This is a mortgage-backed security, which has a value that is derived by value of the mortgages in the bundle.
• Often the MBS is bought by a hedge fund, which then slices out portion of the MBS, let's say the second and third years of the interest-only loans, which is riskier since it is farther out, but also provides a higher interest payment. It uses sophisticated computer programs to figure out all this complexity. It then combines it with similar risk levels of other MBS and resells just that portion, called a tranche, to other hedge funds.
• All goes well until housing prices decline or interest rates reset and the mortgages start to default.

• That's what happened between 2004 and 2006 when the Federal Reserve started raising the fed funds rate.

  Many of the borrowers had interest-only loans, which are a type of adjustable-rate mortgage. Unlike a conventional loan, the interest rates rise along with the fed funds rate. When the Fed started raising rates, these mortgage-holders found they could no longer afford the payments. This happened at the same time that the interest rates reset, usually after three years.

  As interest rates rose, demand for housing fell, and so did home prices. These mortgage-holders found they couldn't make the payments or sell the house, so they defaulted.

• Most important, some parts of the MBS were worthless, but no one could figure out which parts. Since no one really understood what was in the MBS, no one knew what the true value of the MBS actually was. This uncertainty led to a shut-down of the secondary market, which now meant that the banks and hedge funds had lots of derivatives that were both declining in value and that they couldn't sell.

  Soon, banks stopped lending to each other altogether, because they were afraid of receiving more defaulting derivatives as collateral. When this happened, they started hoarding cash to pay for their day-to-day operations. For more, see 2007 financial crisis timeline.

  That is what prompted the bank bailout bill. It was originally designed to get these derivatives off of the books of banks so they can start making loans again.