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Speech by SEC Staff:
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This was prepared as a keynote address for the "Derivatives-Based Investments" Conference on December 8, 2005 in New York City. The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This presentation expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff. |
I. Introduction
It's a pleasure to present the keynote address this morning on the "The Growth of Derivative Securities" as part of the "Derivative-Based Investments" Conference organized by Institutional Investor. Derivative instruments have emerged in recent years as an important tool of investors in our markets. As an economist who happens to hold a senior position with the SEC, I'd like to offer a perspective on the economic aspects of derivative securities in our capital markets. I should emphasize at the onset of my remarks that these do not necessarily reflect the views of the Commissioners of the Securities and Exchange (SEC) or my colleagues on the staff of the Commission.
The increasing use of derivative instruments in our capital markets reflects a variety of factors. Technology facilitates the ability to track the payoffs and risk exposures associated with a portfolio of derivative positions. It also has facilitated the market-making function and auto-quoting in derivatives, tightening derivative spreads and shifting price discovery.1 Clarity in accounting treatment is important for investors to be confident in their use of derivative instruments. The greater use of derivatives also reflects the increasing sophistication of the portfolio risks borne by many investors and the resulting hedging requirements. An important factor in the growth of derivatives markets has been a variety of intellectual advances. The development of economic models for valuing derivative instruments and assessing their riskiness and the increasing sophistication of such models have played a crucial role in the growth of the market. Of course, the valuation of a derivative security depends upon its riskiness and required risk premium, while the risk of a security can be cast as the sensitivity of its value to changes in the relevant economic state variable.2 There has been tremendous diffusion of valuation and risk assessment techniques through both MBA programs and programs in financial engineering. The greater use of derivative instruments has been caused by and resulted in lower trading costs and greater liquidity. The widespread acceptance of synthetic derivatives has reduced costs and increased liquidity and trading. The increased use of derivative instruments has facilitated the greater integration of our financial markets.3
Different investors face diverse economic risks. Derivatives offer a simple and cost effective way to hedge such exposures, at least for some clienteles of investors. Derivatives provide a way to integrate the economic interests of investors on differing economic margins, creating more competition in the financial market and potentially increasing risk sharing and reducing the cost of sharing financial risks.
II. Derivatives and Hedging
The potential usefulness of financial hedging via derivatives can be illustrated by several examples from the market for mortgage-backed securities. The major advance in practice in the development of mortgage-backed securities beyond the basic notion of securitization of loan instruments has been the division of the cash flows to form Collateralized Mortgage Obligations, i.e., CMOs. For example, by splitting the mortgage-backed security's cash flows into suitable tranches, the mortgage-backed instrument can be structured and priced to compete more effectively against corporate and Treasury bonds of various maturities. A particularly interesting way to divide the cash flows of a mortgage and the associated mortgage-backed security is to split these into principal and interest. The resulting securities are called Principal Only and Interest Only Securities. An interesting feature of this division of the cash flows is that for a fixed-rate loan the payments on the Interest Only Security are proportional to the remaining principal balance at each date and therefore, are proportional to the gross revenues received by a loan servicing agent that is paid proportionately to the remaining outstanding balance at each date. Consequently, under the assumption that the servicing costs are small the loan servicing agent is able to hedge the value of its revenue stream against potential movements in interest rates by selling the corresponding Interest Only Securities.
Derivative securities can be used to transform the underlying economic risk or exposure of an investor. One can modify the basic payoff pattern by adding the desired exposure to the basic payoff structure and subtracting the risk exposure that needs to be removed. These modifications can be implemented by the use of derivative securities such as by adjusting through the use of liquid futures contracts or by swapping the desired addition to the basic exposure for the desired subtraction to the basic exposure. Futures or swaps would typically be cost effective ways to achieve the desired exposure. In an investment management context the notion of transforming superior skill in one market sector to another market sector in order to utilize the asset manager's specific skill in the context of the desired exposure is termed "transportable alpha." Notice that the underlying benchmark for the investor's portfolio is distinct from the specific skill of the manager and the relevant exposure of the manager.
The potential power of the ability to use derivatives to transform the underlying character of exposures in frictionless markets is illustrated by portfolio "Separation" theorems applied to the derivatives context. These notions are similar to (1) the consumption-production separation theorem in economics, which states that the optimal intertemporal consumption plan maximizes the consumer's utility subject to the constraint that the firm's production plan maximizes its net present value and (2) the classic Modigliani-Miller Theorem in corporate finance-that the optimal investment decisions are independent of the firm's financial choices in frictionless markets. Returning to the derivatives context, we first note that in frictionless markets that the underlying risks can be costlessly transformed by the use of derivative securities. Under this assumption of frictionless markets there is a separation result between the underlying production risks and choices on the one hand and the optimal consumption choices on the other hand. Similar to the Modigliani and Miller Theorem, in frictionless markets there is a separation result between the underlying risks selected by the asset manager in order to maximize value and those desired and experienced by the investor given his risk preferences. Notice that under this analysis the availability of liquidity in a particular sector (as compared to others) is not crucial to risk pricing in that sector.
The emphasis in the discussion thus far is on the power of spanning the payoff space and completing the market in order to enhance risk sharing by adding to the ability of investors to structure diverse payoff patterns. Pulling out the components of risks that are orthogonal to cash flow needs potentially adds to the investor's value.
Of course, in practice the costs of transformation are not zero, though they should be slight. These costs should reflect the commission costs and spreads associated with using derivatives to transform the risks. For example, the costs should reflect both the resource costs of trading and the market's assessment of the extent of private information in the market in the relevant derivative securities, i.e., the degree of adverse selection. Not only would the costs vary between swaps and futures, but the costs also should vary among different sectors. As an illustration, I note that the liquidity varies tremendously among the futures in different sectors, reflecting the differences in trading depth across sectors and the differences in the extent of adverse selection among these instruments.
III. Derivatives and Price Discovery
While most of my comments thus far have emphasized the role of derivatives in attaining superior risk sharing, I'd like to now address their role in the market's price discovery process. Price determination is a central aspect of markets, i.e., discovery of the underlying value of payoff patterns despite diverse information. The relatively efficient price signals that prevail in the marketplace are important for enhancing productive efficiency and economic growth through superior capital allocation and facilitating the ability of relatively uninformed investors to make suitable portfolio choices. While the asset valuations in our marketplace reflect considerable information, at the same time it is important for there to be strong incentives to engage in the costly analytic and trading activities that result in many investors obtaining diverse informational signals that will be embodied in prices. Derivative securities can enhance price discovery by pricing a static payoff pattern that represents the value of an otherwise dynamic investment strategy, e.g., as illustrated in the Grossman (1988) analysis of portfolio insurance.
As just noted, derivatives provide a mechanism for pricing strategies on an ex ante basis and bearing risk in a structured fashion. Systemic risk or the possibility of correlated defaults across the economy is one of the reasons that there is considerable interest in derivative securities.4 Many asset managers often invest on the same side of a position (e.g., they tend to be on the long side of the credit spread across markets). As the example of Long-Term Capital illustrates, there can be strong external effects across hedge fund investors due to price effects when a major player needs to liquidate significant positions as it implements dynamic strategies.
Since derivative instruments provide a way to use a static payoff structure to value an underlying dynamic strategy, it could be useful for valuing various dynamic liabilities facing firms. In many contexts the "fair" valuation of significant firm liabilities can potentially be determined by "market-based" derivative instruments. Among future applications of derivatives that I feel could be important are structuring derivative designs to properly assess the fair value of stock- and option-based employee compensation and the fair value of a firm's pension liabilities.5 This illustrates how the ability to generate valuation of a derivative instrument can be the source of significant potential demand.
IV. Derivative Valuation, Design and Disclosure
As noted in my introductory remarks, the valuation of a derivative instrument and the assessment of its riskiness are simultaneously determined. The more unusual the instrument or the greater the degree to which the asset payoffs are determined by a tiny fraction of the economic states the harder is the instrument to value and assess the risk. The impact of private information on the part of the investor and consequently, adverse selection leading to wide spreads would be much greater on such hard to value instruments.6 For many instruments adequate disclosures are crucial for valuation and assessing the risk of the derivative security. Of course, the payoffs from derivative securities are sensitive to the fine details of their structure. For example, for some instruments even low probability events substantially influence the relative valuations as illustrated by the example of a residual mortgage tranche, whose duration and pricing are extremely uncertain.
A crucial facet of design of the derivative instrument is the extent to which the seller discloses information, which is either part of the instrument's voluntary design or to meet regulatory requirements. Of course, one would expect that the seller of a derivative security would design the structure to maximize its overall valuation by catering to specific demands by different types of investors.7 In many contexts this may be equivalent to minimizing the adverse selection cost from private information in the hands of the bidders because in a common value auction structure the seller bears the adverse selection costs experienced by the buyer. While the seller of a security often has an informational advantage in designing the instruments, it is important to recognize that in many cases the instrument design is an ex ante decision rather than one that the seller can control with detailed knowledge of the information corresponding to a specific situation. In order to limit the adverse selection cost that it bears from the buyers' informational disadvantage, the seller will often need to commit to a security structure that it plans to utilize over time rather than being able to fine tune the security design with respect to the seller's detailed information.
In many situations the seller of an instrument will be naturally incentivized to provide relatively detailed disclosure so that prospective purchasers with diverse hedging needs and preferences can select those instruments that they especially value and the seller can price discriminate and extract the most value from the underlying payoffs. Detailed disclosure helps support the marketing of derivative components to diverse clienteles.
However, it is important to recognize that the optimal design and disclosures from a buyer's or from a regulator's perspective can differ from that of the seller's and that the specific disclosure regime can affect the division of the surplus.
V. Concluding Comments
In my remarks I have focused upon the economics aspects of derivatives, pointing to some factors underlying its growth. I have tried to highlight (1) the risk-sharing aspects of derivative securities, including their beneficial role in helping to complete the market and facilitate the transformation of risk, (2) the potential benefit from derivatives in facilitating price discovery and (3) the importance of disclosure rules and the design of derivatives.
I welcome your questions.
References
Barkley, T., A. Naranjo and M. Nimalendran, 2005, "The Determinants and Time-Variation of Price Discovery: Evidence from the S&P 500 Index across Stock, Futures and Options Markets," University of Florida working paper.
Chan, N., M. Getmansky, S. Haas and A. Lo, 2005, "Systemic Risk and Hedge Funds," unpublished manuscript.
DeMarzo, P., 2005, "The Pooling and Tranching of Securities: A Model of Informed Intermediation," Review of Financial Securities, 18, 1-35.
Gorton, G. and G. Pennacchi, 1993, "Security Baskets and Index-Linked Securities," Journal of Business.
Grossman, S., 1988, "An Analysis of the Implications for Stock and Futures Price Volatility of Program Trading and Dynamic Hedging Strategies," Journal of Business.
Merton, R., 1998, "Applications of Option-Pricing Theory: Twenty-Five Years Later," American Economic Review, 88, 323-349.
Spatt, C., C. Alexander, M. Nimalendran and G. Oldfield, 2005, "Economic Evaluation of Alternative Market Instrument Designs: Toward a Market-Based Approach to Estimating the Fair Value of Employee Stock Options," Office of Economic Analysis of the Securities and Exchange Commission Memorandum. http://www.sec.gov/news/extra/memo083105.htm
Spatt, C., 2005, "Why Private Pensions Matter to the Public Capital Markets," presentation at an Executive Policy Seminar organized by the Capital Markets Center, McDonough School of Business, Georgetown University. http://www.sec.gov/news/speech/spch111605cs.htm
Subrahmanyam, A., 1991, "A Theory of Trading in Stock Index Futures," Review of Financial Studies, 4, 17-51.
http://www.sec.gov/news/speech/spch120805css.htm
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