Posted by Connie R. Aponte on July 14, 2014 in INTERNATIONAL CAPITAL |

Even on-balance sheet data for measuring the quality of international capital flows—the capital accounts of the balance-of-payments data—are obscured by derivatives used to enhance risk or evade controls or even for benign purposes. Sub-account data, such as portfolio investment, equity investment, foreign direct investment, or long or short maturity fixed interest rate lending, are illusory in the presence of substantial volumes of derivative products.

The remainder of this essay will provide general descriptions of some of the basic derivative products, along with recent data on the extent of the market in derivatives.1 After a discussion of the positive effects of derivatives—the ability to refine the management of risk—the paper will examine the negative aspects of these products—their role in enhancing risk-taking, in evading prudential regulations, taxes, and controls, in channeling the dynamics of currency and financial crises, and in obscuring the meaning of capital account data from the standard balance of payments accounts.

Some Basic Derivative Products

While the list of exotic derivatives products expands almost daily, most derivatives outstanding are relatively simple, consisting mainly offorward contracts, swaps, and basic options, whose notional values are indicative of the magnitude of the market risks that are being acquired or hedged. Structured notes, however, are implicitly highly leveraged products whose notional values generally underestimate significantly the magnitude of the risks taken. Here, I will concentrate only on a few types of swaps and structured notes.

A generic swap of yields is an exchange of the percentage return on one type of asset during a given period for the percentage return on another asset, multiplied by a pre-defmed notional value to convert percentages to cash equivalents. Both returns are observable in securities or banking markets. The swap may involve a periodic exchange of yields for a fixed period of time, and settlement only of the net amount due.

Specifically, for a given currency, an interest rate swap is an exchange of a fixed interest return for a floating return or perhaps one floating interest rate for another. An equity swap or total return swap generally is a periodic exchange of the return on a given share or equity index, including dividends and capital gains, for some interest yield, multiplied by a notional value in a given currency.

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