Hedging, Speculation, Trader risks, Trader returns, Heterogenous expectations speculation, Derivatives trading
Banking and Finance | Securities Law
On April 12, 1994, Procter & Gamble Co. announced that it had incurred pre-tax losses of $157 million from trading in leveraged interest rate swaps, a form of financial derivative. At the time that figure seemed enormous. Yet within a year, Procter & Gamble's misfortune had been overshadowed by that of Orange County, a wealthy California enclave that lost an estimated $2.5 billion of its investment fund as a result of dealings in reverse-repurchase agreements, inverse floaters, and other arcane instruments. Recent months have seen further losses by investment funds, government entities, and even colleges and Native American tribes. Perhaps the most notorious derivatives gymnastics to date, however, have been those performed by the 233-year-old British investment bank Barings PLC. In February 1995, the bank declared itself insolvent as a result of $1.5 billion in losses attributed to a twenty-seven-year-old futures trader who literally bet the bank on a rise in the Nikkei 225 stock index.
Academics and policymakers alike have praised financial derivatives as archetypes of financial progress and innovation. As the victim list grows longer, however, the notion that the burgeoning derivatives markets offer unmixed blessings seems increasingly implausible. Trading in these volatile instruments clearly can be hazardous to the health of the corporations, banks, municipalities, and pension and mutual funds that indulge in it. As the body count rises, it becomes difficult not to suspect that derivatives trading may also impose significant costs on society as a whole.
Federal regulators concerned about the potential downsides to derivatives have focused on the possibility that derivatives trading contributes to "systemic risk," meaning that a derivatives-induced failure of one of the large financial institutions involved in this concentrated market could trigger a chain of related firm failures, including failures of federally insured banks. Any increase in systemic risk certainly poses a serious public problem. This Article focuses, however, on a second, hitherto unrecognized, source of concern: the possibility that, even absent a system-wide crisis, derivatives trading reduces net social welfare by reducing the welfare of derivatives traders themselves: the banks, corporations, and retirement funds to which depositors, investors, and pensioners confide their savings.
Modern financial theory predicts that rational agents deciding where to invest their money should be influenced by only two considerations: expected return, and expected risk (meaning variation in return). The greater the return—or the lower the risk—the more attractive the investment. Because the market participants that deal in derivatives do so voluntarily, commentators generally assume that the derivatives markets serve the traders' interests either by increasing their returns, or by reducing their risks. In the tradition of Adam Smith's invisible hand, derivatives deals are presumed to further the welfare of those who participate in them.
That assumption is defensible in a world where traders face mere risk. This Article will demonstrate, however, that when traders face uncertainty as well as risk, exactly the opposite pattern may hold true. Trading in derivatives under conditions of uncertainty may harm trader welfare by both reducing the returns of, and increasing the risks borne by, the average derivatives trader.
Stout, Lynn A., "Betting the Bank: How Derivatives Trading Under Conditions of Uncertainty Can Increase Risks and Erode Returns In Financial Markets" (1995). Cornell Law Faculty Publications. Paper 445.
Published in: Journal of Corporation Law, vol. 21, no. 1 (Fall 1995).