Academic journal article Economics, Management and Financial Markets

The Derivatives Market and Financial Instability

Academic journal article Economics, Management and Financial Markets

The Derivatives Market and Financial Instability

Article excerpt

1. Introduction

Foreign exchange liberalization leads to major changes in the foreign exchange market, affecting the exchange rate movements and the behavior of market participants, increasing the turnover in FX derivatives for short-term speculation ant the risk management.

Foreign exchange liberalization removes the restrictions, allowing a wide exchange rate band. Therefore, the markets (including the FX swap markets) have incentives to grow.

Band widening also determines an increase in other market segments, which are important for the monetary policy. One of these market segments is the national currency/foreign currency options market, that provides to the market participants the opportunity to speculate and trade the developments in exchange rate volatility (in addition to speculating on the open exchange rate positions). The developments of this market provide information to the monetary policy decision-makers.

One main feature of FX swaps and options is their high turnover, since these two derivative products are one of the major tools of speculation on the currency exchange rate, due to the expected volatility that dominates the domestic currency market.

2. FX swaps

Swaps are an exchange of current and future cash flows. Currency swaps are conversions between two counterparties of a cash flow denominated in two different currencies. One of the simplest category of currency swaps is the forex swap, which is a conversion agreement, where there is an exchange of principal denominated in two different currencies by two counterparties and an agreement to swap back principal at a pre-determined price and a future date (maturity). Thus, a forex swap is similar to a spot forex transaction linked to a forward forex agreement, which means that the parties of the swap transaction buy and sell the currencies in the same time; therefore, they do not open forex positions and they do not expose themselves to a potential change in the exchange rate of the currencies that may determine a profit or a loss.

Forex swaps are seen as a specific category of forwards, but taking into consideration two main differences: i) forex swaps involve cash flow in the present; ii) counterparties do not open forex positions. With other words, a swap is a forex repo (a received or granted loan against a foreign currency as collateral, where the market is very liquid, so that swaps are an important financing tool).

2.1 Forex Swaps Related Money Market Strategies

2.1.1 Acquiring Financial Assets Financed by Forex Swaps

Acquiring financial assets financed by forex swaps represents a foreign currency investment followed by an automatic hedge, through which the buyer gets involved into a swap agreement; the spot leg involves the receiving of the foreign currency and investing the value in a financial asset. The swap's forward leg involves the provisioning of (automatic) hedge against the investment's exchange rate risk. The asset's net return (i.e. the differential of the interest rate) is compensated by the rate of the swap that is paid by the buyer, which is corresponding to the differential of the interest rate.

Thus, one of the motives for entering into this type of agreement is the opening of an interest rate position. If the swap and the acquired asset have different maturities, it might be the case of a profit loss that may be determined by the exposure of the interest rate, which may be induced by the unlike span of the asset side and of the liability side in case of a yield curve shift.

2.1.2 Taking a Spot Forex Position Financed by an FX Swap (Synthetic Forward Position)

By setting a spot forex position which is financed by an FX swap, the derivatives market participant (the speculator) utilizes the more liquid spot market in lieu of the forward segment in order to open a position. But due to the fact that the market participant does not intend to purchase the foreign currency denominated asset, so it has no intension of changing its balance sheet, it steps into a swap transaction by financing the position, where the spot leg is antonymous to the initial spot transaction. …

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