THE recent price behaviour of world financial markets is presenting a host of new challenges to the financial services industry.
Nowhere has this been more apparent than in the United States interest rate environment during the first and second quarters, when relatively modest increases in short-term rates set off a whole sequence of events in the global stock and bond markets.
So far, no clear analysis has emerged about the cause of the disruptions. Commentators have blamed the volatility on a host of factors, ranging from the arcane to the supernatural.
We expect that the real culprit can simply be found in the enhanced efficiency of financial markets, much of which emanates from financial derivatives. The unique impact these instruments have on the markets continues to be poorly understood from the macro standpoint.
The proliferation of derivative instruments constitutes a powerful influence on the price behaviour of the underlying cash instruments thanks to a process called transference. Transference is an intricate mechanism, but understanding it belies a basic assumption about the effect of derivatives - that it is a zero sum game.
Take an example. A bank dealing in the over-the-counter (OTC) derivatives markets, including the swaps or options markets, may try to match counter-parties within the framework of its own book to earn a spread.
In such an instance, the impact of the trade on the markets would be negligible, because risk has been exchanged evenly between two willing counter-parties. But seldom do banks have the ability to find perfect matches for their derivative trades.