Derivatives, Fiscal Policy and Financial Stability

- - Chiara Oldani and Paolo Savona

The massive use of derivatives and securitization by sovereign states for public debt and deficit management is a growing phenomenon in financial markets. Financial innovation can modify risks effectively run and alter the stability of the public sector finance. The experience of some developed and developing countries is surveyed to look at main instruments used and aims of public finance. Financial stability of the public sector is analyzed considering financial innovation use. The case of Italy and its scarce disclosure of information are presented. An IS-LM model is used to capture the effect of financial innovation on fiscal policy for high indebted (European) industrialized countries, with deficit constraints, starting from Blanchard (1981). The use of financial innovation can have various effects over debt and deficit management, given binding external burden (like the European criteria) as far as risks are properly considered, expectations of fiscal policy are coherent with that of markets, and no exogenous shock occurs.

© 2005 IUP. All Rights Reserved.

Equity Prices, Credit Default Swaps, and Bond Spreads in Emerging Markets

- - Jorge A Chan-Lau and Yoon Sook Kim

This paper examines equilibrium price relationships and price discovery between credit default swap (CDS), bond, and equity markets for emerging market sovereign issuers. Findings suggest that CDS and bond spreads converge despite various pressures that arise in the market. In most countries, however, we do not find any equilibrium price relationship between the bond and CDS markets and the equity markets. As for price discovery, our results are mixed. This stands in contrast to the empirical findings on corporate issuers in the United States and Europe.

© 2004 International Monetary Fund, IMF Working Paper WP/04/27 (www.imf.org). Reprinted with permission.

Derivatives Markets: Sources of Vulnerability in US Financial Markets

-- Randall Dodd

This paper studies the ways in which derivatives markets pose several types of public interest concerns to the US economy by creating new and greater sources of vulnerability. The first and most obvious concern is the way in which derivatives markets expand risk-taking activity relative to capital. By enhancing the efficiency of transactions and the leveraging of capital, derivatives can increase speculation just as well as they lower the cost of hedging. Secondly, derivatives markets can provide new opportunities for destructive activities such as fraud and manipulation; and they can facilitate unproductive activities such as outflanking prudential financial market regulations, manipulating accounting rules and evading or avoiding taxation. The third concern involves the creation of new types and levels of credit risk as OTC derivatives contracts are traded in order to shift various types of market risk. The new credit risk is not subject to collateral (i.e., margin) requirements, and is not handled in the most economically efficient manner. The fourth concern is the liquidity risk, especially in the interest rate swaps market, which is susceptible to creditworthiness problems at one or more of the major market participants. The last concern is systemic risk, arising especially from the OTC derivative markets, and the strong linkages between derivatives and underlying asset and commodity markets. The paper will conclude with a proposal for prudential regulatory measures that will address these public interest concerns.

© 2005 Edward Elgar Publishing Ltd. This article has been published in Gerald Epstein ed. Financialization and the World Economy, Edward Elgar Press. Reprinted with permission.

Is Futures Rate an Unbiased Predictor of Future Spot Rate?

-- Ash Narayan Sah and G Omkarnath

This paper empirically examines the relationship between spot rate and futures rate for the period June 2000 to February 2004. The futures must be an unbiased forecaster of the future spot rate, otherwise informed traders could profit from the bias by taking one position in the cash market and the opposite position in the futures market. Two models are employed for testing the efficiency of market by OLS method. Our results establish the fact that futures market in India is not efficient and informed traders could make profit by employing some strategy. Futures rate is not a predictor of future spot rate.

© 2004 IUP. All Rights Reserved.

Book Review

Credit Derivatives: Application, Pricing and Risk Management

- - Gunter Meissner

In the recent past credit derivatives market has evidenced tremendous growth following increased risk exposures of various corporate entities and the resultant financial debacles. In this context it is essential to understand the reasons behind the genesis of these instruments and their applications in a credit risk environment. Insights into the conceptual and contemporary aspects of credit derivatives segment will provide a clear understanding about the efficiency of these instruments as strategic credit risk management mechanisms.

© 2005 Gunter Meissner. All Rights Reserved. The IUP holds the copyright for the Book Review.