Financial markets

• Pages: 402-455
• Author: William A. Klein,John C. Coffee Jr.,Frank Partnoy

402

Chapter 6

FINANCIAL MARKETS

I. INTRODUCTION

We began this book by focusing on the relationships among the

human actors involved in business organizations or entities. To this

point, we have covered many aspects of these relationships, as well as

the corporate finance tools that participants in business enterprises use

to arrange and order their affairs. Now, we want to place these basic

concepts in the context of modern financial markets. As with Chapters 4

and 5, there is a break of sorts from our previous coverage, but there is

continuity as well. At their heart, financial markets are devices for

allocating control, risk, and return, and for resolving, or attempting to

resolve, some of the tensions and conflicts that arise in business relation-

ships. But the financial markets also present enormous complexity and

new problems, which we will cover here.

During 2008, the markets experienced a crisis that reshaped the way

regulators and market participants think about finance and financial

market regulation. This Chapter will examine the financial instruments

that were at the center of this crisis, particularly derivatives. It also will

look at the evolving structure of financial markets and the relevant

efficiency and behavioral theories that attempt to describe market be-

havior. We close with a Section on new regulatory approaches. The

financial and regulatory complexity described in this Chapter will help

illuminate many of the core concepts we have covered throughout this

book.

Given the complexity of modern financial markets, important ques-

tions arise about the tradeoffs between efficiency and transparency. This

tradeoff is important to many of the topics in this Chapter. On one hand,

financial market participants benefit from innovations that reduce the

costs of trading, that ‘‘complete markets’’ by allowing access to new

financial instruments, and that enable parties to avoid the costs associat-

ed with antiquated regulation or market structures. On the other hand,

improvements in these efficiency-related areas do not come without

costs, and there is a dark side to financial innovation. As the costs of

individual trades has declined and investors and institutions have ac-

cessed new markets and instruments, the information gaps between

buyers and sellers of financial instruments frequently have increased.

Likewise, as exposure to financial risks has increased, disclosure of that

403RETHINKING BUSINESS ORGANIZATIONSCh. 6

exposure has declined. Overall, as markets have become increasingly

deregulated, information asymmetry has increased, at least in some

market segments. Although deregulation may have produced some effi-

ciency gains, there also appear to be costs associated with decreased

transparency. A continuing policy question will be where the tradeoff

should be struck between the reduced costs of deregulation and the

reduced transparency that seems to follow from it.

Before we can address the policy questions associated with the

challenges of modern financial markets, we will need to develop some

vocabulary and tools. That examination begins with derivatives. We

want to take a step back now, and use the language and characteristics

of derivatives to help us rethink the nature of business organizations.

II. RETHINKING BUSINESS ORGANIZATIONS

USING DERIVATIVES

A. CATEGORIES AND USES OF DERIVATIVES

Derivatives are financial instruments whose value is ‘‘derived’’ from

some underlying instrument or index. The market for derivatives is the

largest market in the world. As of 2009, the ‘‘notional value’’ of deriva-

tives outstanding, as measured by the size of the instruments and

indices underlying the derivatives, was more than half a quadrillion

dollars, larger than all of the world’s other markets—stocks, bonds,

commodities, and real estate—combined.

There are two basic categories of derivatives: options and forwards.

An option represents the right to buy or sell something at a specified

time and exercise price. A forward represents the obligation to buy or

sell something at a specified time and price. Some of the vocabulary of

derivatives varies depending on where they are traded, on regulated

exchanges or in private ‘‘over-the-counter’’ markets. For example, for-

wards traded on exchanges are called futures, while options traded on

exchanges are still called options. Over-the-counter derivatives, those not

traded on exchanges, often are abbreviated as ‘‘OTC’’ derivatives.

It is useful to recognize upfront that derivatives are used primarily

for three purposes: hedging, speculation, and arbitrage. Hedging refers

to a reducing risk. For example, a farmer could use futures or forwards

to lock in the price at which he will sell wheat he expects to harvest in

three months. The forward contract would obligate him to sell, and his

counterparty to buy, the wheat on a specified future date. Alternatively,

he might purchase a put option on wheat, to insure against price

declines. Such options have been traded on exchanges in the United

States since 1984. A wheat put option would give him the right to sell

wheat at a specified price, and would protect him against a decline below

that price. We can think of a future or forward as a symmetric hedge

(the farmer would both give up the potential for gain if prices rose and

eliminate the risk of loss if prices fell), whereas an option would be an

404 FINANCIAL MARKETS Ch. 6

asymmetric hedge (the farmer would pay a premium to insurance

against the risk of loss if prices fell, but would keep the potential for gain

if prices rose).

Speculation refers to taking on increased risk, with the expectation,

or at least the hope, of increased return. Speculators trade both options

and forwards, betting that assets are mispriced, in the same way specu-

late by trading shares and bonds. Speculators frequently use derivatives

as a more efficient or less costly means of getting financial exposure to

the underlying asset. For example, if a speculator were to believe that a

particular stock was likely to rise in price, it might prefer to buy a

security future, a contract for the future delivery of that stock, because

the rules governing securities futures permit traders to borrow more

money than the rules governing stocks. Alternatively, the speculator

might use options to calibrate a bet so that it would pay money only if

the stock rose above a particular price. A speculator who believed a $20

stock would increase substantially could buy a call option with an

exercise price of $30. Such a highly speculative option would be cheap–

say, $1—just like car insurance with a high deductible, or a bet to win

$100 on a long shot at the horse track. If the stock price increased to

$50, the call option buyer would make $20—the difference between $50

and the $30 exercise price—on a position that cost just $1 upfront. In

both cases, the future and the option would enable the speculator to pay

less money upfront for a bet, relative to the upfront cost of buying the

underlying stock.

Derivatives have been criticized because they frequently are used as

a means of obtaining more leverage than would be available in the

market for the underlying assets. On futures exchanges, margin require-

ments are set by the exchange to restrict leverage, and they are recalcu-

lated on a daily basis. But in the OTC markets, margin is a matter for

private negotiation, and more leverage may be possible. Others have

criticized derivatives speculation as inherently unproductive activity

than diverts resources and human capital away from other pursuits.

Defenders of derivatives argue that speculation provides liquidity and

helps makes markets more efficient by reducing transaction costs. Al-

though there is little possibility at present that derivatives will be

abolished or curtailed by governmental action, the leverage available for

their purchase is receiving Congressional attention, and increased mar-

gin requirements are likely.

Arbitrage refers to capturing riskless profits based on pricing anom-

alies among financial markets and products. In the purest sense, one

might use derivatives to synthetically replicate the payoffs of an asset for

a cheaper price. For example, if call options on a stock are cheap, and

put options on the same stock are expensive, a trader might create

‘‘synthetic stock,’’ replicating the economic profile of stock by buying

cheap call options and selling expensive put options. The options would

mimic the upside and downside profile of the stock, but at lower cost.