The Office of the Agriculture Futures Trading Commission Agriculture Futures Exchange of Thailand No

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The Office of the Agriculture Futures Trading
CommissionAgriculture Futures Exchange of
ThailandNorthwestern University Alumni of
ThailandSecurities Analysts AssociationThe
Stock Exchange of ThailandUniversity of Chicago
Club in Thailand Proudly present Derivatives
Weapons of Mass Destruction, or Smart Bombs?
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Derivatives Weapons of Mass Destruction, or
Smart Bombs?

• by
• Christopher L. Culp
• Adjunct Professor of Finance

The Stock Exchange of Thailand Bangkok, 6 July
2004
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Agenda

• Derivatives Historical Perception and Reality
• Designing a Successful Futures Contract
• The Role of Hedge Funds, Day Traders, and
  Speculators
• Some Principles to Keep in Mind

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What Are Derivatives?

• Derivatives are transactions involving the
  purchase or sale of an asset (or its
  cash-equivalent) at a time and place other than
  the here and now.
• Types
• Forward-based (e.g., forwards, futures, swaps)
• Option-based (e.g., calls/puts, products with
  embedded options)
• Markets
• Exchange-traded (e.g., futures, futures options)
• Over-the-counter (e.g., swaps, forwards, options)

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How Significant is Derivatives Activity?
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The Public Perception of Derivatives
Financial Weapons of Mass Destruction
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The Public Perception of Derivatives

• In his March 2003 letter to Berkshire Hathaway
  shareholders, Warren Buffet described derivatives
  as weapons of mass destruction.
• More than 200 proposals to prohibit, tax, limit,
  or significantly regulate derivatives activity
  have surfaced in the last century in the U.S.
  alone.
• Adam Smith noted criticisms of derivatives in his
  Wealth of Nations

• Criticisms of derivatives are the historical
  rule, not the exception!!!!

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The Alternative Perspective
Financial Smart Bombs
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Benefits of Derivatives

• Facilitate hedging very specific risks
• Price/Quantity Risks
• Paired closely with underlying asset
• Allow firms to exchange one risk for another
• Market risk is exchanged for credit risk
• Credit risk is exchanged for operational risk
• Etc.
• Facilitate commercial operations
• Supply chain management
• Basis risk management
• Highly liquid and easy to negotiate
• Relatively low transaction costs

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The Futures Model

• Futures are highly liquid and arenas for price
  discovery in addition to risk transfer thanks to
  the unique design of the futures clearing house
  system

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Then Why All the Controversy?

• There is always a loser in a derivatives trade.
• Smart bombs can be guided to the wrong risk
  targets
• Barings
• Metallgesellschaft
• Procter Gamble
• F2 Key Precision Risk Targeting Incident
• Design failures
• Bad markets
• Bad contracts

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Agenda

• Derivatives Historical Perception and Reality
• Designing a Successful Futures Contract
• The Role of Hedge Funds, Day Traders, and
  Speculators
• Some Principles to Keep in Mind

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AFET

• The business of an exchange mainly concerns the
  contracts its lists for trading, clearance, and
  settlement
• Fees
• Revenues from price and ticker sales
• Initial Contracts at AFET
• 3rd Grade Smoked Rubber Sheets
• 5 Broken White Rice
• On the Horizon
• Tapioca
• Shrimp

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Contract Choice and Design

• Four out of Five new futures contracts fail and
  are de-listed within the first five years of
  trading
• Two possible reasons
• Lack of demand for the contract itself
• Poor contract design
• Of course these two reasons are related to one
  another

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Six Characteristics of a Successful Futures
Contract
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1. Underlying Risk

• The underlying market must be large and expose
  firms to price or quantity risk
• Price and/or quantity volatility must be a
  problem in the market
• Example AFET Rubber
• Thailand is the largest rubber producer
• Price and quantity are both highly volatile
• Capital is at risk and needs to be hedged

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2. The Right Amount of Basis Risk in the Contract
Design

• The cash flows on the futures contract should be
  correlated as highly as possible to the cash
  flows of the major hedgers
• Some embedded optionality is okay
• Example delivery options
• In fact, some optionality and basis risk
  encourage trading!!!

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3. Non-Monopolistic Supply

• The underlying commodity should be competitively
  produced
• Vertical integration is a substitute for hedging
• Example ALCOA spent a fortune opposing aluminum
  futures why???
• Futures facilitate competition
• Price discovery reveals the monopoly mark-up

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4. Symmetric Risk

• Futures need both longs and shorts to survive
• In agricultural commodities, this is usually easy
• Farmers and producers are natural longs with a
  natural demand for short hedging
• Processors and intermediaries are natural shorts
  with a natural demand for long hedging
• Speculators play an important role in increasing
  the depth of both the long and short sides of the
  market

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5. Adequate and Regular Information Releases

• Futures are traded they need volume as well as
  open interest to generate liquidity and price
  discovery
• For trading, you need regular releases of high
  quality information about the underlying product
  suppy
• Example the failure of CPI futures in the U.S.
  was attributed to the lack of updates in the
  Consumer Price Index there was no volume

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6. Market Integrity

• The rules of the exchange should discourage
  anti-competitive practices like manipulation
• Exchange risk management must be at the extreme
  edge of conservative
• Default scenario and troubled account disposition
• Intra-day margin
• Member surveillance
• The clearing house should have a credit quality
  beyond question or doubt
• Supplement default fund with insurance or credit
  derivatives through a guaranty
• Segregated accounts

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Agenda

• Derivatives Historical Perception and Reality
• Designing a Successful Futures Contract
• The Role of Hedge Funds, Day Traders, and
  Speculators
• Some Principles to Keep in Mind

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The markets hedge load

• Symmetric risk is usually not enough for a
  futures market to succeed
• The hedge load of a futures market is the
  proportion of speculators relative to hedgers
• Speculators include
• Day traders
• Commercials practicing short-term position-taking
• Position takers (e.g., hedge funds)

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Isnt Speculation Destabilizing?

• NO!!!!!!!!!!!!!!!!!!!!!

• The vast bulk of the academic literature suggests
  that speculators actually moderate the volatility
  of a market
• Increasing liquidity
• Taking contrarian positions during big market
  moves

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One Integrated Market

• Successful derivatives quickly become integrated
  fully with the associated cash market
• Futures generally lead cash because of lower
  transaction costs and higher liquidity
• But leading cash does not mean that the tail
  wags the dog
• In fact, derivatives help spread the impact of
  shocks across markets and over time
• We can really see the effects of an integrated
  market by looking at U.S. market during the
  October 1987 stock market crash

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October 1987
futures
cash
SOURCE L. Harris, The October 1987 SP 500
Stock-Futures Basis, J. Finance 44(1) (1989).
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October 13, 1987
SOURCEA. W. Kleidon and R. E. Whaley, One
Market? Stocks, Futures, and Options During
October 1987, J. Finance 47(3) (1992).
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October 19, 1987
SOURCEA. W. Kleidon and R. E. Whaley, One
Market? Stocks, Futures, and Options During
October 1987, J. Finance 47(3) (1992).
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October 19, 1987 (U.K. FTSE-100)
SOURCE A. Antoniou I. Garrett, To What Extent
Did Stock Index Futures Contribute to the October
1987 Stock Market Crash? The Econ. J. 103(421)
(1993).
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The October 1987 Crash

• Futures led cash but did not cause cash
• Slow computers and printer jams in New York
• Stale limit order book
• Derivatives and program trading moderated the
  speed and extent of the crash in the U.S.
• The biggest problems came when the cash and
  derivatives markets disconnected!!
• When arbitrage could not occur, a vicious
  downward spiral occurred in both markets

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Consider How Things Might Have Been
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Avoid Trying to Regulate Speculation

• The birth of SIMEX was in response to restrictive
  regulations on speculation in Osaka
• Margin is not a good tool for controlling
  volatility high spec margins can decrease
  legitimate speculation and the hedge load
• Taxes on speculation decrease liquidity and the
  hedge load
• Circuit breakers are a mixed blessing
• Provide a cooling off period
• Accelerate the rate of decline before the closure
• Delays price discovery
• Hong Kong fell over 46 despite being closed for
  a week in October 1987

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Still a Role for Prudential Supervision

• Ensure capital adequacy and financial integrity
  of speculators
• Adopt segregated accounting for proprietary
  trading
• Audit trails to protect customers from
  inappropriate frontrunning
• Monitor positions for concentration and
  cross-default risks (e.g., domino effects)

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Agenda

• Derivatives Historical Perception and Reality
• Designing a Successful Futures Contract
• The Role of Hedge Funds, Day Traders, and
  Speculators
• Some Principles to Keep in Mind

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1. Let the Market do Most of the Regulating

• The AFTC will play an important role, but the
  AFET has a very strong incentive to impose strict
  regulations of its own
• Try to focus on institutions and not products
• New contract approvals have placed futures at a
  historical disadvantage to OTC derivatives
• Hard to define products in the law
• Better to regulate users of derivatives rather
  than derivatives themselves to the extent
  political regulation is warranted

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2. Transparency

• More high quality information about an underlying
  asset promotes trading
• More high quality information about an exchange
  promotes confidence in the exchange
• Example
• The failure of Barings showed us the need for
  exchanges to become more transparent with the
  public
• Exchanges should also share surveillance
  information with one another

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3. Conservatism

• New exchanges may be tempted to keep margins low
  and to enforce rules lightly dont
• The market will attract volume when market
  participants are totally confident in the
  clearing house and exchange risk management
  function
• External insurance can help signal that
  integrity

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4. Governance

• Do not bog down an exchange with a lot of
  unnecessary committee structures
• Adopt a strong, forward-looking management and
  directorate
• Firms with capital at risk will pay closest
  attention
• Outside directors can also help
• Keep a forward-looking perspective on technology,
  in particular

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Mind the Trends

• Demutualization
• Demutualization has costs and benefits
• The trend toward demutualization in futures does
  impact market structure and competitiveness
  issues
• Vertical Disintegration
• Outsourced clearing and settlement
• Horizontal Integration
• Straight-through processing and shared platforms
  for cash, securities, and derivatives
• Alliances
• Cooperate when it makes sense
• Compete when it makes sense
• Know your comparative advantage

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The Verdict?
OR
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Please download the presentation slides
fromwww.saa-thai.org