The Ethics of Banking: Conclusions from the Financial Crisis (Issues ...

84 6 The Ethical Economy of the Market for Derivatives
are willing to do so. 2 Futures and options therefore serve the primary purpose of
hedging, the protection of an asset or value against a future change in value and
the transfer of the risk of such a movement in value from the party who would
rather hedge than bear the risk to another party who is willing to bear the risk in
exchange for a fee. However, for those in need of protection to be sure that their
demand for futures and options will be matched by a supply, there must be suppliers
of futures contracts who either hold the contrary expectation about the future, and
have an equal demand for protection against the complementary movement in value
that their complementary future expectation leads them to anticipate, or else a group
of suppliers who are motivated by speculation and/or arbitrage to ensure a supply
of futures or options. The demand for hedging and the meeting of that demand
presupposes a supply of futures and options motivated by speculation, and hence
a certain volume of speculation in futures and options. Both the hedging and the
speculation motives determine the market for futures and options.
Structured finance products are investment vehicles like certificates (e.g. index
or basket certificates) which comprise a least one derivative element. 3 Unlike shares
or other capital-market products, but also unlike fixed-interest securities, they are
structured by incorporating a derivative component. They can be seen as hybrids of
credit-market and capital-market instruments, although the term “hybrid security”
is used for products like convertible bonds which can actually be transformed in
nature. A classic hybrid product is the convertible bond, a bond – i.e. a loan to
the corporation – which is converted into a share in the corporation, a share of its
common stock.
In fact, structured products themselves are hybrid securities, in that they are
hybrid constructs consisting of a fixed-interest and a derivative component. 4 The
invention of the collateralized debt obligation created a form of security and a
financial instrument that combines loan elements with elements of equity financing.
The distinction between the credit market and the capital market cannot be
stringently maintained for these securities. They belong to both markets. The creation
of structured products or certificates likewise results in financial instruments
that are hybrid in character and cannot be ascribed to just one market or the other.
2 Cf. also RENÉ M. STULZ: “Should We Fear Derivatives?”, Journal of Economic Perspectives,18
(2004), pp. 173–192, although he understates the risks of the massive expansion of derivatives.
3 Cf. SARYAJIT DAS: Structured Products and Hybrid Securities, Hoboken, NJ (John Wiley) 2nd
edn. 2001, p. 1: Structured products are “derivative-embedded securities, a security that combines
the features of a fixed income instrument with the characteristics of a derivative transaction (in
effect, the return profile of a forward or option on a selected class of asset.)”
4 SARYAJIT DAS: Structured Products 4: Equity, Commodity, Credit and New Markets: 2, Hoboken,
NJ (John Wiley) 2005 (Swaps & Financial Derivatives Library), gives a list of structured products
including: equity derivatives (including equity swaps/options, convertible securities and equity
linked notes), commodity derivatives (including energy, metal and agricultural derivatives), credit
derivatives (including credit linked notes/collateralized debt obligations (“CDOs”)), new derivative
markets (including inflation linked derivatives and notes, insurance derivatives, weather derivatives,
property, bandwidth/telephone minutes, macro-economic index and emission/environmental
derivatives) and tax based applications of derivatives.