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Financial Markets: A Tool for Transferring and Managing Risk?

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Part of the Ethical Economy book series (SEEP,volume 41)

Abstract

The last financial crisis showed that the world economy is globally exposed to all kinds of risks. When equity and real estate markets capture the creation of global wealth, derivatives markets make it possible to value and transfer risk. Hedging and speculation are the main motivations of the participants who buy and sell the numerous products traded in these markets. Following Robert Shiller’s writings, this chapter aims to show that these markets, whether organized or not, may provide new ways to manage most of the risks both firms and individuals are facing. However, at the same time, huge risk transfers may foster speculation and lead to new systemic risks, as revealed by the credit derivatives market in recent years. This paper considers how the financial markets can better serve people (individuals, long investors, funds) in the context of the current economic situation. Firstly, the paper characterizes the risks individuals are facing and to what extent they can be measured and hedged through the financial markets. Then, examples of risk transfer are shown using the example of the real estate market. The role of information required to construct relevant indices that can be used as underlying assets is also highlighted. Finally, the unwanted effects of risk transfer are considered, especially the role of speculation and the possible increase of systemic risk. The conclusions underline the importance of the quality of information that should be at the heart of new rules designed to regulate the development of derivative products.

Keywords

  • Real Estate
  • Financial Market
  • Systematic Risk
  • Future Market
  • Credit Default Swap

These keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.

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Notes

  1. 1.

    Collateralized debt obligations (CDOs) are a type of structured asset-backed security (ABS) whose value and payments are derived from a portfolio of fixed-income underlying assets. CDOs securities are split into different risk classes, or tranches, whereby “senior” tranches are considered the safest securities. Interest and principal payments are made in order of seniority, so that junior tranches offer higher coupon payments (and interest rates) or lower prices to compensate for additional default risk.

  2. 2.

    An asset-backed security (ABS) is a security whose value and income payments are derived from and collateralized (or “backed”) by a specified pool of underlying assets.

  3. 3.

    A mortgage-backed security (MBS) is an asset-backed security or debt obligation that represents a claim on the cash flows from mortgage loans through a process known as securitization.

  4. 4.

    A credit default swap (CDS) is a swap contract in which the protection buyer of the CDS makes a series of payments (often referred to as the CDS “fee” or “spread”) to the protection seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) experiences a credit event.

  5. 5.

    The ABX is a credit derivative swap contract that pools lists of exposures to mortgage-backed securities.

  6. 6.

    A structured investment vehicle (SIV) is an operating finance company established to earn a spread between its assets and liabilities like a traditional bank. A lot of SIVs were created before the 2008 crisis.

  7. 7.

    Residential mortgage-backed securities (RMBS) are a type of bond commonly issued in American security markets. They are a type of mortgage-backed security which is backed by mortgages on residential rather than commercial real estate.

  8. 8.

    The closeout is the right of a counterparty to unilaterally terminate contracts under certain specified conditions.

  9. 9.

    Netting is the right to offset amounts due at termination of individual contracts between the same counterparties when determining the final obligation. Netting legislation covering derivatives exists in most countries with major financial markets.

  10. 10.

    Collateral used in derivatives markets remains under the control of the counterparty and may be liquidated immediately upon a covered event of default.

  11. 11.

    Quality of information and transparency are not only technical recommendations but also constitute an ethical requirement (cf. Benedict XVI 2009, 65).

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Acknowledgment

The author wants to thank Paul Nagy for his comments, suggestions, and reviews of this chapter.

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Correspondence to Michel Baroni .

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Baroni, M. (2012). Financial Markets: A Tool for Transferring and Managing Risk?. In: Schlag, M., Mercado, J. (eds) Free Markets and the Culture of Common Good. Ethical Economy, vol 41. Springer, Dordrecht. https://doi.org/10.1007/978-94-007-2990-2_11

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