Impact of the introduction of the risk management products

Dr. San-Lin Chung

Department of Finance

National Taiwan University

In this chapter Smithson (1999) discuss the impact of

the introduction of the risk management products from

three aspects:

1. The impact on the markets for the underlying assets

2. The impact on the economy

3. The impact of the derivative markets on each other

Three dimensions of analysis

The financial derivatives may have the following impacts on the markets for underlying assets:

• The volatility of the underlying asset price• The speed adjustment in the underlying asset

market• The bid-ask spreads in the underlying markets• Trading volume for the underlying asset

The impact on the markets for the underlying assets

The impact on price volatility• Derivatives were blamed for the cause of the

October 1987 crash.• However the empirical evidence does not support

the increased-volatility story

Table 3-1

The effects of triple-witching hours

On the third Friday of March, June, September, and

December three types of derivative contracts expire –

stock index option, stock index futures , and options on

stock index futures. The maturities used to occur at the

close of the market. The last trading hour on those

Fridays is called the triple-witching hour.

The effects of triple-witching hours• Expiration effects: the volatility of stock returns

was higher on average for futures’ expiration days than for non-expiration days.

• The expiration effects became insignificant probably due to the change in the settlement of index-linked contracts from the close of trading to the open of trading on expiration days.

To conclude: look at Figure 3-1• Derivatives volatility• Volatility derivatives

The empirical evidence suggests that the market adjust

to information more quickly, i.e. market is more

efficient.

Table 3-2

The impact on adjustment speed

Two possible explanations (or determinants) for bid-ask spread

• Inventory cost• Information asymmetry among traders

The introduction of derivatives generally cause the bid-

ask spread for the underlying asset to decline.

Table 3-3

The impact on bid-ask spread

Theory suggests that trading volume on the underlying

asset should increase when derivatives are introduced.

The empirical evidence show that the introduction of

derivatives has had little effect on market-adjusted

trading volume in the underlying market.

Table 3-4

The impact on trading volume

Table 3-5

Summary

• The social benefits of financial innovation far outweigh the cost.

• Improvement in the allocation of risk within the financial system

• Help firm to hedge their risk without diversification of their investment

• Increase liquidity and efficiency of financial markets

The impact of risk management on the economy

• The impact of the OTC derivative market on the exchange-traded derivatives

• The trading volume in the OTC derivatives seems increasing at the expense of the exchanges

• However, Merton argue that the OTC markets still needs the exchange market to hedge their positions.

The impact of derivative markets on each other