Business Daily Media

swaps, options and other derivatives aren't just for the financial elite

  • Written by Richard Holden, Professor of Economics, UNSW
swaps, options and other derivatives aren't just for the financial elite

One of the biggest trends in economics over the past 40 years has been so-called “financialisation” – whereby an increasing proportion of GDP in advanced economies comes from the financial sector.

This has involved the development of ever more sophisticated “financial instruments” such as swaps, options and other derivative securities.

The global mobility of financial capital has also given banks and hedge funds massive piles of money with which to make leveraged bets on everything from stock prices to the fourth derivative of the volatility of South American currencies — which is (I kid you not) a contract on the rate of change on the rate of change on the rate of change in currency value.

As Harvard economists Robin Greenwood and David Scharfstein have noted[1], in 1980 the financial sector accounted for 4.9% of US GDP. By 2007 it was 7.9%. Since 1980, they note, the financial sector’s share of GDP has increased at 13 basis points a year, compared with 7 basis points a year over the 30 years prior.

The dark side of financialisation

Financialisation’s dark side is known to anyone who has seen the movie The Big Short.

The financial sector went from being “boring” in the 1970s and early 1980s to being a playground for clever, sometimes unscrupulous traders driven by huge incentives and the prospect of paydays in the tens, or hundreds of millions.

Given some of the ugly and venal behaviours we have seen, it is hardly surprising there has been a huge backlash against big banks and hedge funds. Too often these behaviours have brought the global financial system to the brink.

As far back as 1998 a rinky-dink little hedge fund (backed by two Nobel Prize-winning economists, Myron Scholes[2] and Robert Merton[3], Long-Term Capital Management, believed it had an unbeatable system to play these markets. Instead it turned US$1 billion into US$125 billion of toxic derivatives bets, almost bringing down financial markets around the world.

Then there are the collapses of Bear Stearns and Lehman Brothers due to the subprime mortgage crisis, which precipitated the global financial crisis of 2008.

Read more: Lessons from the 2008 financial crisis for our coronavirus recovery today – Recovery podcast series part six[4]

The bright side of financialisation

But it’s not all bad news. A new paper[5] by MIT economists Felipe Iachan and Alp Simsek with Plamen Nenov at the Norwegian Business School explores the idea that financial innovation can provide investors, small and large, with more choice, with positive results for their savings decisions and investment returns.

Before the advent of mutual funds, it was very hard (and expensive) for small investors to invest in the stock market. The advent of such funds increased stock-market participation in the US from about 10% of households in the 1950s to more than 50% by the end of the 1990s.

In Australia, effective stock-market participation is now even more pervasive due to our superannuation system, whereby almost anyone who has had a full-time job has stock investments.

What does this mean for the amount of savings, and for asset prices?

You might think that increased portfolio choice would decrease savings — and you’d be in good company.

The traditional literature in financial economics predicts just that. The logic is that people save to protect themselves against risks — such as losing their job because the industry in which they are employed is battered by international competition or technological change.

By investing in stocks, they hedge that risk by exposing themselves to other industries and firms. If the industry in which they work turns down their stock market investments might be going up.

As a result of this more efficient saving, households don’t need to do as much saving as if they were holding piles of cash or government bonds. Because those savings aren’t as diversified. So savings should go down and interest rates should go up, all else equal.

Contradicting evidence

But, as the authors of this new paper point out, the evidence is that “while there is a well-known negative trend in saving rates since the 1980s, the trend has been much weaker for participants”.

Put differently, stock-market participants have increased their saving relative to non-participants since the 1980s.

And that’s controlling for wealth, so it’s not about how much people have to invest but in what, and how much, they invest.

They go on to offer a framework in which investors who hold different beliefs about asset returns can express those beliefs more effectively when financial innovation provides them with a greater choice of investment products.

This isn’t just a matter of theory — elegant though the authors’ theory is. The empirical evidence suggests this “choice channel” explains two important facts about investment returns in recent years.

First, stock market participants save more than non-participants. Second, “similar households seem to receive more dispersed portfolio returns in recent years”.

Pros and cons

There has been plenty of justified criticism of the financial sector in recent years. Risky and unseemly things have been done, hurting regular folk a great deal.

But we shouldn’t forget new and better financial products can also help small-time investors. Perhaps the leading example is index funds that allow them to hold a diversified portfolio of the whole stock market at very low cost — a fee of, say, 0.05% a year, rather than the 1% commonly paid stock pickers for inferior performance.

This is why the option of a low-cost index fund should be at the heart of Australia’s superannuation system.

References

  1. ^ have noted (www.aeaweb.org)
  2. ^ Myron Scholes (www.nobelprize.org)
  3. ^ Robert Merton (www.nobelprize.org)
  4. ^ Lessons from the 2008 financial crisis for our coronavirus recovery today – Recovery podcast series part six (theconversation.com)
  5. ^ new paper (www.aeaweb.org)

Authors: Richard Holden, Professor of Economics, UNSW

Read more https://theconversation.com/vital-signs-swaps-options-and-other-derivatives-arent-just-for-the-financial-elite-158297

Business Today

Utilising communication tech to alleviate employee burn out

Hybrid work solidified into the business model in 2021 – plain and simple. Jabra research revealed 42 per cent of employees last year requested leadership to help make their virtual workspace more comfortable. Employees are ...

Space Machines readies for liftoff securing launch services deal with SpaceX

SpaceX to carry Space Machines' Optimus Orbital Transfer Vehicle as part of its April 2023 mission. Optimus is one of the largest spacecraft built in Australia and furthers Australia’s sovereign capabilities toward in-space...

Deliver business benefits through operational excellence

As Australian businesses emerge from the pandemic lockdowns and draw up plans for growth, increasing numbers are adopting a strategy of operational excellence. Operational excellence involves everyone in an organisation and f...

Modern slavery conference to take on the criminal enterprises and address global injustices

Influential experts from around the world will take part in a unique international online summit targeting modern slavery being hosted by Australian charity Freedom for Humanity later this month. Modern slavery is a process...

Unit4 Appoints Tania Garrett as Chief People Officer

 Unit4, a leader in enterprise cloud applications for people-centric organisations, today announced the appointment of Tania Garrett as Chief People Officer. Tania will oversee the company’s people success function wh...

FIVE reasons why you should set up an instant office instead of a fixed lease

Australia is now on the cusp of very volatile economic period. As the world tries to pick up the pieces after two years of global lockdowns and constant setbacks, we continue to face the aftermath of COVID on many levels. Acc...

Business Daily Media Business Development

Utilising communication tech to alleviate employee burn out

Hybrid work solidified into the business model in 2021 – plain and simple. Jabra research revealed 42 per cent of employees last year requested leadership to help make their virtual wo...

David Piggott, Managing Director ANZ at Jabra - avatar David Piggott, Managing Director ANZ at Jabra

Space Machines readies for liftoff securing launch services deal with SpaceX

SpaceX to carry Space Machines' Optimus Orbital Transfer Vehicle as part of its April 2023 mission. Optimus is one of the largest spacecraft built in Australia and furthers Australia’...

Business Daily Media - avatar Business Daily Media

India's employee hostels are often like prisons – but young women garment workers don't always see it that way

Kavitha, 18, earns a living at a clothing factory in the southern Indian state of Tamil Nadu. Like many of her colleagues, she lives in accommodation provided by the factory, where she share...

Andrew Crane, Professor of Business and Society, University of Bath - avatar Andrew Crane, Professor of Business and Society, University of Bath

Shortage of workers threatens UK recovery – here’s why and what to do about it

For the first time since records began, there are more job vacancies in the UK than unemployed people, according to the latest monthly labour market figures. This has been driven mainly by a...

Donald Houston, Professor of Economic Geography, University of Portsmouth - avatar Donald Houston, Professor of Economic Geography, University of Portsmouth

A central bank digital euro could save the eurozone – here's how

Blockchain bailout?4K_HeavenThe European Central Bank and its counterparts in the UK, US, China and India are exploring a new form of state-backed money built on similar online ledger techno...

Guido Cozzi, Professor of Macroeconomics, University of St.Gallen - avatar Guido Cozzi, Professor of Macroeconomics, University of St.Gallen

Deliver business benefits through operational excellence

As Australian businesses emerge from the pandemic lockdowns and draw up plans for growth, increasing numbers are adopting a strategy of operational excellence. Operational excellence in...

Chris Ellis, Director Pre-Sales at Nintex - avatar Chris Ellis, Director Pre-Sales at Nintex



NewsServices.com

Content & Technology Connecting Global Audiences

More Information - Less Opinion