Academic journal article Accounting & Taxation

The Role of Derivatives in the Financial Crisis and Their Impact on Security Prices

Academic journal article Accounting & Taxation

The Role of Derivatives in the Financial Crisis and Their Impact on Security Prices

Article excerpt

ABSTRACT

This study takes on two divergent notions concerning derivatives; that they are dangerous instruments (Warren Buffet) versus the concept that they help to reduce risk (Allen Greenspan). These notions are assessed from the perspective of the recent Financial Crisis in which derivatives were assigned a good deal of the blame for the meltdown. This study analyzes three different study periods; Pre-Crisis (2003, 2004, 2005), Crisis (2008, 2009, 2010), and Post-Crisis (2011, 2012, 2013-lst quarter). In addition, the study also analyzes three different groups of firms containing 100 firms each; firms engaging in the use of derivatives and accepting TARP funds, firms engaging in derivatives and not accepting TARP funds, and firms not engaging in derivatives and not accepting TARP funds. Results indicate that for Crisis and Post-Crisis periods, investors tend to discount accounting earnings releases in making investment decisions. For the firms using derivative and not accepting TARP funds and firms not using derivatives and not accepting TARP funds, the results across all three study periods are almost identical, accounting earnings reflect positive information-enhancing signals on security prices. This does not mean that security prices continued a steady upward trek, but only that investors placed a greater positive reliance on earnings in making investment decisions, in other words, they tended to not discount earnings releases.

JEL: G3, M41, N2

KEYWORDS: Derivatives, Security Prices, TARP

INTRODUCTION

In the fall of 2008, the U.S. Congress implemented the Emergency Economic Stabilization Act as a result of the financial crisis which began that same year. The Act created the Troubled Asset Relief Program (TARP). It was the largest component of the government's measures to address the subprime mortgage crisis and resulted in expenditures of close to $1 trillion taxpayer dollars. These "troubled assets" were defined as residential or commercial mortgages, securities, obligations, or other instruments which in many cases were utilized for speculative purposes under the banner of "derivatives."

Derivatives, also referred to as "futures contracts," have functioned for more than 100 years to act as a hedge against fluctuations in prices of items such as commodities, metals, energy products and financial instruments. Control of derivatives was insured under the Commodity Exchange Act (CEA) of 1936, which called for regulation and oversight of derivatives. Significant growth in the use of derivatives occurred at about the same time the Federal government decided to deregulate them in 2000 through passage of the Commodity Futures Modernization Act (CFMA). As a result, derivative growth along with the simultaneous removal of all controls associated with them, help lead to the worse financial meltdown in the U.S. economy in more than 75 years.

Derivatives are viewed by many as complex and murky in nature, however, they are not new to the financial scene. The early derivatives market began in the 1860s and consisted of farmers and grain merchants coming together in Chicago to hedge price risks in such commodities as com, wheat, soy and other grain products. This began what came to be known as "futures" contracts. The traditional futures contract is an agreement between a seller and a buyer that the seller will deliver a product to the buyer at a price agreed to when a contract is first entered and the buyer will accept and pay for the product at some agreed upon future date. In addition, the buyer has the opportunity to liquidate some or all of the product prior to delivery. Although developed initially in the agricultural sector, derivatives quickly spread into the metals, energy and financial sectors.

Because of the debilitating effect of agricultural prices during the Depression, President Roosevelt recommended to Congress the first market reform that impacted derivatives. The Commodity Exchange Act (CEA) of 1936 restricted, as far as possible, the use of futures purely for speculative purposes, thus relieving commodity producers of injury and thus producing some amount of control over the use of derivatives. …

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