Financial derivatives and their importance in international financial management

For some, the word “derivative” is synonymous with everything wrong with capital markets, trade for trade, rampant profit, nothing to do with real people’s financial needs. These are some of the charges against the financial derivative, but is that a fair reflection or is there a softer side to this seemingly irredeemable beast.

Indeed, the origin of derivative contracts begins with meeting the needs of ordinary people. Midwestern farmers in the mid-1800s faced financial ruin due to severe swings in the price of corn. By the time they paid for seed corn plus the cost of growing and harvesting it, they faced the possibility of selling it at a loss. In fact, the simple idea of ​​agreeing on a fixed price in the future that secured a guaranteed profit for the farmer was the birth of modern financial markets with the first corn contracts being offered on March 13, 1851 at the Chicago Board of Trade. in order for the farmers to hedge the price of maize, there had to be someone willing to offer a fixed price in the future – the speculator argues. A simple and obvious fact overlooked by those who would denounce the market forces is that there can be no hedgers without speculators.

It is noteworthy, however, that more than a hundred years would elapse before the concept of a forward hedge would translate from agricultural needs and commodity trading to the financial markets proper. The International Monetary Market (IMM) offered the world’s first foreign currency forward contract on December 31, 1974. Again the emergence of these early derivative contracts that arose from the need to stabilize exchange rate fluctuations, as the post-World War II international monetary agreement known as Bretton Bos broke down.

As each new layer of abstraction built on previous layers, the world of derivatives trading grew to encompass more and more aspects of the financial markets. For example, interest rate futures were added to the already existing currency futures and gold futures with the creation of US Treasury futures in January 1976.

Over the past 30 years, the trend has continued with ever-increasing complexity. Options on futures into the early 1980s, followed by over-the-counter swaps and options in the mid-1980s and continued with credit derivatives in the 1990s and insurance derivatives in the early 2000s.

What started as a simple means of hedging the price of corn has grown into a global market trading trillions of dollars a day. The interactions and correlations between markets once considered separate are now closely linked, with price shocks rippling from one market to another. The development of computer systems has been the single most important “enzyme”, without which it simply would not have been possible for markets to grow.

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Ironically, it is now the inability of computerized risk management systems to keep up with the markets that is hindering further development. The IT systems landscape within most investment banks is now very complex with many different systems interacting in ways that are difficult for a human to understand. Armies of software specialists and consultants maintain fragile systems; “If it ain’t broke, don’t fix it” is the mantra of many. But a nest of vipers lies hidden, a tangled web of fragmented and fragile interconnections, leaving trading firms vulnerable to significant losses from possible system failures. Operational risk within IT systems has the potential to cause the collapse of the entire business. The time has come for many banks to face this problem and tackle it at its roots. Instead of adding more and more patches to existing systems, radical investments are needed to clean up and establish a structured, well-designed system landscape.