Financial derivatives use : a literature review

Abstract

As the authors have highlighted in the previous chapter, derivatives have come under wide criticism for their supposedly destructive nature in the financial markets and the effects of this spilling into the real economy (Sharma, 2008). McClintock (1996) notes that derivatives are widely perceived as financial instruments that have led to financial losses or failures of firms. Moreover, he states that it is believed that their (derivatives) market has brought increased international financial fragility to the global economy. Together with transactions that were once heralded as hallmarks of market efficiency (Kojima, 1995), such as conglomerate mergers (Lewellen, 1971), leveraged buyouts (Jensen, 1989) and junk bond offerings (Andersen, 1995), derivatives have been receiving mixed reactions from the public, frightened of the firm-specific risks and the systemic risks. The firm-specific risks are composed of the credit, legal, market, liquidity and management risks, whereas the systemic risks involve that of ‘greater competition between banks and non-bank financial institutions, greater interconnectedness of financial markets, increasing concentration of derivatives trading, the reduced disclosure of financial information through off-balance sheet activities’ and increased market disturbances due to financial and telecommunication innovations (Becketti, 1995). There have been strong debates on the reasons why derivatives should exist and several arguments by theorists against the role of derivatives. Even their purpose of existence has been criticised (Dodd, 2002c ). The author, therefore, feels that it is necessary to understand the reasons for which derivatives have come into existence in the financial economy and their prevailing nature throughout the decades of developments in the global financial economy (Steinherr, 2002). Therefore, this chapter sets the background and theory for the study, by highlighting literature on derivative use, their impact, noting characteristics of derivatives users and controllers and their perceptions and explaining the challenges of safe derivative use (Fig 2.1). The information in this chapter is necessary to corroborate findings highlighted later. It is deemed important by the author to determine what literature has to say about the instrument and about their users characteristics.