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Impact of the introduction of the risk management products

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Title: Impact of the introduction of the risk management products


1
Impact of the introduction of the risk management
products
  • Dr. San-Lin Chung
  • Department of Finance
  • National Taiwan University

2
Three dimensions of analysis
  • In this chapter Smithson (1999) discuss the
    impact of
  • the introduction of the risk management products
    from
  • three aspects
  • The impact on the markets for the underlying
    assets
  • The impact on the economy
  • The impact of the derivative markets on each other

3
The impact on the markets for the underlying
assets
  • 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

4
  • 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

5
  • 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.

6
  • 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.

7
  • To conclude look at Figure 3-1
  • Derivatives ? volatility
  • Volatility ? derivatives

8
The impact on adjustment speed
  • The empirical evidence suggests that the market
    adjust
  • to information more quickly, i.e. market is more
  • efficient.
  • Table 3-2

9
The impact on bid-ask spread
  • 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

10
The impact on trading volume
  • 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

11
Summary
  • Table 3-5

12
The impact of risk management on the economy
  • 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

13
The impact of derivative markets on each other
  • 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.

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