The range of financial securities has been increasing sharply over the past decade. The main reason for that is that financial institutions are in search of new customers to gain profits. Customers (investors) are also looking for new products which offer them attractive returns, thus further facilitating the process of financial engineering.
Due to their flexibility derivative instruments provide financial institutions with more possibilities for financial engineering than other asset classes. In fact, derivative instruments allow financial institutions to generate profits on shares and bonds by issuing derivative products on those underlying asset classes.
163 The advantages of greater product availability are that markets generally attract more investors, as they find products that are appealing and satisfy their return expectations. With a wider product variety and more investors investing in a particular security, market liquidity generally increases, thus improving trading conditions and price determination, as well as security for investors.
Due to a wider range of products available investors gain access to markets which were previously difficult for them to access. A relevant example is the introduction of futures and options on various commodities. Before financial institutions introduced such derivative instruments it was difficult for private retail investors to access the highly lucrative commodities market. Even institutional investors had problems trading in those markets, as it was often necessary to physically buy the underlying commodity. This is no longer necessary and investors can trade in commodities similar to trading in shares (Commerzbank 2006:17).
Another advantage of greater product availability is that investors have more securities with which to diversify their portfolios (Fischer 2007). Thus, allowing investors to use asset classes and securities that are protecting their returns and even generate profits in bear markets.
In South Africa, the Johannesburg Stock Exchange has, over the past ten years, continuously increased its derivative product range in order to make derivative instruments more attractive to a broader range of investors. The latest products featuring on the Johannesburg Stock Exchange are Can-Do options and futures which were explained in Chapter Three, Section 3.4.3. These products have been traded since 2006. In addition, the Johannesburg Stock Exchange increased its product range by offering new futures on underlying commodities, such as gold, platinum and crude oil in 2009 and sorghum in 2010 (Johannesburg Stock Exchange 2010i, Johannesburg Stock Exchange 2010r).
A disadvantage of continuously increasing the product range is that investors tend to have too many options available and cannot screen all investment alternatives efficiently. This can possibly lead to ineffective investments and high losses, especially concerning derivative instruments (Steinbrenner 2001:80-85).
164 By increasing the product range financial institutions have to make sure that there is sufficient demand for their latest products and that investors are willing to invest in it. If this is not the case investors will end up in markets with very little trading activity and infrequent price determinations, thus reduced liquidity. This in turn increases the risks investors are exposed to, as their portfolios may then include investments that develop unfavourably and they are unable to sell (HSBC-Trinkhaus 2007:13).
Another point to consider is that financial institutions need to be careful that products do not become too complex and/or do not serve a useful purpose for investors. The 2008/2009 financial crisis has revealed how dangerous financial engineering can be. The introduction of credit derivatives on sub-prime mortgages created a lucrative market and investors, particularly institutional investors generated large profits. All this came to a halt when interest rates in the USA rose and more debtors started to default on their payments, thus leaving the credit derivatives market and various financial institutions in dire straits.
Nevertheless, investors generally prefer markets with a broad range of products available in order to make sound investment decisions. In addition, a study conducted by Fischer (2007), shows that product availability is important to investors. Thus, the following proposition can be stated:
P17: Investors are more likely to use derivative instruments in markets where numerous products are available.
4.4 SUMMARY AND CONCLUSIONS
The decision whether or not to use derivative instruments in a portfolio depends on a number of variables, the most prominent of which are summarised in Table 4.1 and Table 4.2. It should be noted that this is not an exhaustive list of variables, merely those that are typically cited in the investment management literature.
165 TABLE 4.1: Summary of the variables and propositions included in the conceptual model regarding investor characteristics
Variables Propositions
Investor characteristics
The investor’s needs, goals and return expectations
P1: Investors with clearly defined investment goals and return expectations are more likely to use derivative instruments.
P2: Investors with high return expectations are more likely to use derivative instruments.
The investor’s knowledge of and familiarity with financial markets and different asset classes
P3: Investors who have a greater knowledge of financial markets are more likely to include derivative instruments in their portfolios.
P4: Investors who have a greater knowledge of different asset classes are more likely to include derivative instruments in their portfolios.
P5: Investors who have a greater knowledge of different derivative instruments are more likely to include derivative instruments in their portfolios.
The investor’s level of wealth P6: High net worth private investors are more likely to use derivative instruments than less affluent private investors.
P7: Institutional investors with higher levels of assets under management are more likely to use derivative instruments than smaller institutional investors.
The investor’s level of risk tolerance P8: Risk-averse investors are more likely to use derivative instruments for hedging purposes than risk-seeking investors.
P9: Risk-seeking investors are more likely to use derivative instruments for speculating purposes than risk-averse investors.
166 TABLE 4.2: Summary of the variables and propositions included in the conceptual model regarding market characteristics
Variables Propositions
Market characteristics
The level of volatility in a market P10: Investors are more likely to use derivative instruments when markets exhibit a great deal of volatility.
The level of standardisation in a market (ease of trading)
P11a: Investors are more likely to use derivatives which are standardised. P11b: Investors are more likely to use derivatives which are traded on organised (not over-the-counter) markets.
The level of regulation in a market P12: Investors are more likely to use derivative instruments in well-regulated markets.
The level of information available on derivatives and the transparency of price determination in a market
P13: Investors are more likely to use derivative instruments in markets where information is readily available and price determination is transparent.
The level of liquidity in a market P14: Investors are more inclined to use derivative instruments in markets that offer high levels of liquidity.
Taxes P15: Investors are more likely to use derivative instruments the lower the taxes are.
Brokerage costs P16: Investors are more likely to use derivative instruments the lower the transaction costs are.
Product availability P17: Investors are more likely to use derivative instruments in markets where numerous products are available.
167 All of the above-mentioned variables certainly play a role in investors’ decision- making processes regarding the use of derivative instruments in their portfolios. However, not every investor perceives one variable as important as the other and not every investor would agree that one specific variable is the most important one. It strongly depends on investors’ experience, attitude, preferences and knowledge.
There are certainly variables that are generally more important for investors’ decision-making process, such as knowledge of financial markets, different asset classes and derivative instruments. Without proper knowledge about financial markets and the products offered in these markets it is impossible to make a wise investment decision.
Derivative instruments are perceived to be risky, thus investors’ risk tolerances and their risk-return profiles play an important role in deciding whether or not to use derivatives in their portfolios.
Due to the 2008/2009 global financial crisis and the fact that many of the derivatives blamed for this crisis were traded in over-the-counter markets, which were not transparent, investors seek markets that are regulated, transparent and provide enough information relating to the different products and their prices.
Another variable that should play an important role is liquidity. Once financial securities are liquid investors can easily trade them and prices are provided on a continuous basis.
The following chapter will discuss the research design and methodology adopted in this study.
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