Derivative Markets In Asia Essay

1983 words - 8 pages

z3251872

Felix Kang

FINS2622 – Emerging Capital Markets

Assignment

Derivatives Market in Asian Countries

2

An Overview
The purpose of this report is to examine the following; to discuss the derivatives markets in Asian economies whilst simultaneously discussing the benefits and risks posed by these markets to their financial systems. In conclusion, I will propose a set of specific policy actions/recommendations aimed at reducing these risks. Growth in emerging markets has been due to several factors including privatizations, participation of foreign institutional investors, increase in the domestic investor base, and increased IPOs. In a nutshell, economies are taking ...view middle of the document...

(Fratzscher 2006) Two key derivatives products that do not necessarily have a positive influence in emerging Asian markets are (Dodd 2000); • Foreign exchange forwards and foreign exchange swaps. The trouble with this type of transaction is that they are not always collateralized, which exposes foreign exchange derivatives counterparties to credit risk. This has been the largest source of credit losses in derivative markets because of defaults on foreign currency forwards in East Asia and Russia; • The largest threat to financial market stability that did not directly involve foreign exchange exposure was the use of embedded derivatives, put options, in loan and bond debt contracts. These options on the debt principal enabled lenders to recall their principal in the event of economic trouble. The effect caused was to drain the development of country financial markets of liquidity just at the time it was most urgently in need. Because the options were puts, it granted the lenders the

Derivatives Market in Asian Countries

3

right to reclaim their principal, and hence reduce their risk of adverse macroeconomic conditions or other circumstances, which would reduce the ability of their borrowers to repay their debts. It also reduced their exposure to increases in dollar or other hard currency interest rates. Furthermore, it allowed them to outflank tax and regulatory requirements because the put-able loans could be treated like long-term debts even though they potentially functioned like short-term ones. The presence of put-able debt in lending to developing economies raises several policy concerns. First, the attached put lowers the borrowing costs and this in turn encourages more borrowing and lending. Second, the tax and regulatory treatment of put-able debt often incorrectly treats it as long-term debt. Third, it creates liquidity shortages in the event of a financial disruption, and it does so just at the time in which liquidity is crucial for the successful functioning of the financial sector.

Driving Factors and Benefits of Derivative Markets
There are obvious positives to flow from derivatives trading; foreign exchange derivatives, which provide hedging tools to corporations as they can match the currency composition of their assets and liabilities, interest rate derivatives which allow both financial and non-financial institutions to seek the most attractive financing in international capital markets and to hedge against interest rate mismatch in their assets and liabilities, and finally equity derivatives which have usually reduced volatility and strengthened liquidity in equity markets, enhanced returns to institutional investors such as mutual or pension funds, whilst reducing the cost of equity for firms. So in summary, the main driving factors for derivative markets in Asia have been the substantive benefits from risk sharing in more complete capital markets, corporate demand for hedging tools, institutional needs for...

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