Firstly, let me begin by confessing that I am an investment banker, which is quite possibly the worst thing that one can admit these days.  We are told by the media and the politicians that we are all a bunch of reckless and testosterone-fuelled gambling addicts whose ‘casino’ trading and ‘financial weapons of mass destruction’ almost brought about the end of the world as we chased down multi-million pound bonuses.

To make matters worse, we deal in strange sounding instruments like futures, options, swaps, swaptions, barriers, caps, floors, collateralised debt obligations, and mortgage backed securities plus we deal in oil, coal, carbon emissions, electricity, live hogs, butter, gold, iron ore, freight and even frozen concentrated orange juice.  We use powerful computers and sophisticated programmes called algorithms.  Some of us hide behind secretive and eerie sounding investment vehicles called hedge funds, based in exotic sounding tax havens like the Cayman Islands.

And the losses can be huge: in 1995 Nick Leeson famously brought down Barings bank with losses of £800 million.  While at the time that figure seemed enormous, it now only ranks as the 14th largest bank trading loss – the number one loss is seven times that figure, Howie Hubler of Morgan Stanley managed to rack up losses of over $9 billion in another market most people would never have heard of, credit default swaps.

The conclusion of many people is that this type of banking is bad, and should cease to exist, after all a banks job is to take deposits and then use that money to lend to house buyers and businesses.  This perception fails to understand the vital role played by banks and these instruments.

Before I go further I should add a caveat that when I talk about bankers and banking from now on I exclude all the criminal and wilfully reckless activity that was undertaken by a few individuals such as Leeson and Kerviel.  For the purpose of this article I am only referring to legal and properly supervised and monitored banking activity.

So: why the need for derivatives?  I am going to take as a simple example a corn farmer.  The farmer plants his corn as usual at the start of spring.  From this point on he has no control over the quantity or quality of his corn, beyond the usual insect and pest repellents.  He has no control over the weather, nor does he have any control over world corn prices.  In the event of very good weather the harvest will be good and therefore the price that he can expect to get at market will decrease, similarly if there is an outbreak of, say, Foot and Mouth, demand for corn as animal feed will similarly decrease taking down the price of the crop.

The farmer may wish to lock in the value today of his harvest in autumn.  He does this by selling a forward contract (called a future) into the market, the buyer being a person who has exposure to harvest prices being higher than they are today, such as a breakfast cereals manufacturer.  Simply put, the farmer and his customer agree a price for the corn today even though it is not delivered until harvest time.  Both the producer and the manufacturer have risks that they wish to lay off.  In this inter-market type of transaction there is not much need for any other intermediaries, but where there are multiple risk exposures then the need for more market participants are required.

Or take for example a Japanese car manufacturer wants to open up a car plant in the UK.  The company has debt obligations and profits payable in yen, its UK running costs are paid in sterling, the car parts are largely priced in dollars, and if it wants to export the cars into Europe it has an exposure now for Euros being paid in the future.  For the company to make this plant investment, it must mitigate these currency and loan rate risks – risks that it has no control over, like the farmer and his weather exposure.

Firstly, the company has to ensure that its borrowing costs connected to the plants build do not rise, and it does this by using short term interest rate futures (STIRs) to fix its rate payable.  Then the company has to address its currency risks and it does this by using forward rate agreements (FRAs), and it moves the currency risks associated to the plant investment elsewhere, and fix the foreign exchange exposure now for the length of the plant’s operation across yen, sterling and euro.

It is the function of the bank to take this risk and effectively insure the value of the plant.  In addition to taking on an interest rate risk and a four way currency rate risk it is also, necessarily, taking on risk that the company itself will go bust or the market for cars in the UK and Europe will collapse, so the bank needs to mitigate those risks.  The bank will then insure the company risk by either selling short some of the car manufacturer’s stock or by buying bankruptcy insurance known as Credit Default Swaps.

So, in order to attract long-term investment into the economy we require the banks to warehouse, disseminate and then lay off the risks attached.  If we do not, then the costs of these types of plant investment would sky rocket, as the companies would have to internalise these risks in perpetuity.  The banks function is to take the risk and then lay off the component parts into the market to match other investors’ needs, just in the same way our breakfast cereal manufacturer takes the risk out of higher corn prices now for delivery in autumn.  It is all the same principle.

The media will also have us believe that these complex trades create volatility in the market and make it more difficult for investment.  This is polar to the truth.  The growth in these instruments has engendered specialist speculative trading houses who will buy and sell these risk products as assets in their own right.  These are called hedge funds, privately financed investment companies.  These funds have grown in numbers and size over the last twenty or so years.

The increased number of market participants all chasing the same profits mean that the markets become more efficient and prices become more transparent competitive.  The result is that the costs attached to our Japanese company building their plant in the UK are lowered.  The more the number of specialist tools or financial products (derivatives) mean that it has become easier to invest here or in any other open market economy, and it is all thanks to the banks willingness to take risk.

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