Financial Derivatives in Theory and Practice in China

Financial Derivatives in Theory and Practice in China CHAPTER 1 INTRODUCTION 1.1 BACKGROUND Financial derivatives is often an efficient policy of the risk management which is been used in modern economy worldwide. The financial derivatives grow on huge scale and very significant into a well accepted definitions, measurement and the revelation of the conventional financial accounting essentials. The financial derivatives has many advantages and it is been used worldwide. Though, some risks occur in the use of financial derivatives. The management of the financial derivatives become more essential in the modern economy. With the rapid growth of the modern economy, more financial risk exists during the development process which involves the frequent use of financial derivatives, the use of the derivatives assist against a potential risks and use of financial derivatives also reveals to the user a huge risk. Financial derivatives are also important through the progress of financial derivatives. Globally, the world economy is fast growing which is leading to so many difficulties in the financial derivatives worldwide which are creating more problems for financial derivatives. However this problem requires the introduction of regulatory body such as government to take over in order to supervise the financial derivatives. The supervision of financial derivatives plays a vital role in modern economy while lack of regulation in financial derivation will lead the financial market into disorder, chaos and confusion. This might destroy the entires nations economy. Financial derivatives without regulation will attract a big potential economic risk. For the financial market globally, such economic crisis affects the economy worldwide. 1.2 OBJECTIVES OF THE STUDY China has a huge economy which is growing rapidly. There various types of financial derivatives in china, which are widely used in the financial market. This research will analyze the financial derivative in Chinas financial market and also discuss the classic supervision (regulations) and the analysis of the performance of the supervision procedure. China financial market, its advantage and the risks that exist in the classic financial derivative in China will also be reviewed. This research will reveal major classic in the various types of financial derivatives in china and verify the uses of all the financial derivatives in order to demonstrate its performance of those financial derivatives. The supervision of financial derivatives will also lead to reviewing the Chinas financial environs. The major purpose of this research is to establish the usage of financial derivatives against the financial derivatives. The findings of the research from both the financial derivatives and role of supervision in China will provide an overall insight in the China financial market and also conclude by making some recommendation on the usage of financial derivation and the status of the supervision of financial derivatives in China. 1.3 STRUCTURE OF THE RESEARCH This research reviews the overall literature on financial derivative in the past with a focus on the impact of the financial derivative, the benefits of the practise of financial derivative and the potential risk of the use of financial derivative. The supervision of the financial derivative analysis will be reviewed with the use of Journals and report. Subsequently, this research work will focus on the case study for the research methodology; the case study is the Chinas financial market. This research model information is gathered from both Chinas financial market and the supervision of the financial derivatives in China. Information is however collated in china using the position of a standard financial derivative in China. Using the position of a standard financial derivative in China, the analysis of financial market in China is reviewed with some journals and reports which was use as the data in support of the research and the most vital data is collected by the Chinese national statistics. The research will use both the qualitative and quantitative analysis method, this used to analyse the research data. From the research of classic financial derivative that is practise in China and the supervision of financial derivatives in China. This research will adapt the SLEPT method (Social factor, Legal factor, Economic factor, Political factor and Technological factor) to review the entire china financial markets while the SWOT (Strengthen, Weakness, Opportunities and Threats) method will be used in reviewing the financial derivative in the direction of the Chinas financial market, the functions of the supervision of the financial derivatives in China will also be reviewed. Finally, there will be a brief conclusions and provide some recommendations on both China financial for market and supervision of the financial derivatives. The limitations of the study will be highlighted and references for further reading will also be listed at the end of this research. CHAPTER 2 LITERATURE REVIEW 2.1 THE IMPACT OF FINANCIAL DERIVATIVE The financial derivatives have a direct influence on the organization. A financial derivative is a good policy of risk management. Froot et al (1993) observed that the peak level of investment and capital spending are selected at the same time. They recommend that financial cost risk management should have a particular dominant goal, this enable the company to have access to cash to make a price improving investments. The risk management model rely on the fundamental premises that the essentials of establishing corporate value is creating good investment and the essentials to creating good investment is generating adequate cash within, in order to use it to find those investments. Nance et al (1993) and Mian (1994) discover a statistically important clear relationship between the tax credits and the practise of risk management instruments. Dolde (1995) reported a clear and an important relation between tax loss carry forwards and the practise of risk management instrument which include hedging. Dixon Bhandari (1997) found that calls for supervision through a rise in legislation are not generally accepted. Although the supervisory body main focus is that the stability of inter market could be strictly undermined without greater supervision. Guay (1999) studies financial derivative responsibilities in organizations by initiating derivatives practises. The outcomes were consistent with organization practising derivatives to hedge and not to expand, entity risk. Organization risk is measured in different ways which reduces following the use of derivatives. The study observes a decrease in risks and decisions to introduce derivatives programs vary from hedging. The outcome highlights the significance of hedge accounting laws that incorporate the influence of derivatives and hedged items at the same time. Fender (2000) discovers some basics of corporate finance of monetary economics examine the influence of corporate risk management policies on the monetary transmission system. They employed an easy model of a financial speed up to sort the information asymmetries, they are the core of the entire models of the transmission system, it establish motivation for corporate hedging activities, that is cash flow administration, they realise that these principles, in turn, reduce the influence of monetary policy degree which is lower to the clear cost of capital effect. Billing (2002), describe the reasons behind the protection and enlightened on how auditors should review the different problems raised from the utilisation of financial instrument. Heilliar et al (2004), access the influence of financial reporting standard 13: Derivatives and different financial instruments, implementations and disclosures which focus is on the treasury department responsibilities. The researchers deliberately conduct interviews with the workers of the UK treasury department in order to review their behaviours towards and observed the impact of FRS 13. At large, the treasurer reply at an advantage to the standard and carefully reviewed the narrative disclosure to be specifically useful. The numerical disclosures were comprehensive and focused. The rapid growth in the financial derivatives also has an influence on Chinas financial market. Ba Shusong (2004) believes that financial derivatives have played a vital role in the growth of Chinas market. Subsequently, El-Masry (2006) stated that big firms often used derivatives than average or smaller firms, public companies often use derivatives than the private companies. The use of derivatives is ultimate in the midst of international firms. The findings reveals that most firms that do not use derivative instrument is attributed to the fact their experiences are not important and the major reasons they avoid derivatives are, they focus on the experiences requires by FASB rules under derivatives activity, fees of creating and sustaining derivatives activities go beyond the expected profit, foreign exchange risk is often managed with derivatives and interest rate risk is often managed with derivatives and interest rate risk is risk that is subsequently managed risk and the study reveals that the main reason for the use of hedging with derivatives is supervising the volatili ty in liquidity. Bartram (2006) explores the incentive and use of non financial firms with respect to using options in managing risk activities. The study realize that an important number of 15 – 55% of the companies not within the financial sector practise the options which shows the fact that options are very flexible risk management instrument which can be useful to hedge different types of exposures both linear and non-linear, it also discover that it rely on the correlation between price and quantity risk, the optimal hedge portfolio involve different combination of both linear and non linear risk management instruments. The accounting ways and the effects of liquidity can influence the selection of derivatives. Eckstein et al (2008) study the impact of organization using derivatives which applies Statement of Financial Account Standards (SFAS) no 133; it shows the degree of cumulative effects of differences in accounting formulas from the annual income statement adopted, market response to earnings pronounced and the major effect of financial ratio. The outcome reveals that the important negative unpredicted returns were noticed around earnings pronouncement dates. Abnormal earnings correlate with the cumulative effect instead of the differences in earnings per share from operations which reveals that surprises connected to changes in accounting, it is also established that companies with resources unrealized profit and losses are connected to hedging with derivative instrument. 2.2 THE MERITS OF FINANCIAL DERIVATIVES There are several advantages of financial derivatives from 1990s McAllister and Mansfield (1998) studies the responsibilities and ability of financial derivatives investment property portfolio management and also focus on the difficulties of direct investment in commercial property. They also analyse and the major principles and all different types of derivatives, they rounded it up that the possibilities of financial derivatives to mitigate most of this difficulties which is connected with direct property investment that is studied. They also decided on Property Index Certificates (PIC) has been narrow down with shareholders and ought to produce rise in interest rate and the use of derivatives product within the assets both in the UK and global institutional shareholders. Tyler and Stanley (2002), Counter Sheedys call for further readings through the practical examination of the equity derivatives market in US and UK, quarrelling that while link in this market do, to a certain degree, showing features a typical of broader and indeed inherent, to over-the-counter derivative exchange. After that, Zivney et al (2006) discovers the possibilities of using dividend plans by individual shareholders. This plan was raised from the 2003 tax law changes which reduce tax rates on dividends received while abandoning the short term tax rate on capital losses unaffected. Freeman et al 2006, realize that the credit derivatives market is control by big banks and insurance firms who does business within themselves. The growth of credit derivatives market develops into more liquid and transparent. Freeman emphasize that thee a various easy and practical ways in which organisation can use credit derivatives to manage risk to show the empirical strengths and weakness of a particular approach. Klimczak (2008) produce a detailed assessment of the main contemporary firms hedging theories. The study focus on a sample of 150 companies listed on the Warsaw stock exchange which shows features shared by companies using hedge. 2.3 RISKS ATTACHED TO FINANCIAL DERIVATIVES From the above, the literature review shows various advantages of financial derivatives on the risk management of finance. However, some risk occurs in the operation of financial derivatives. Financial derivatives have been faced with so many criticisms this mostly is due to large loose because of leverage and borrowing. Laker (2008) examines that as the derivatives permit shareholders to earn huge returns from small movement in the basic assets price. Though shareholder might lose more money if the basic asset price moves against them drastically and the financial derivatives might expose shareholders to counter party risk and all types of financial derivatives have different risks at different level to this effect. Also financial derivatives will stand as an unsuitable large amount of risk for little and mostly for shareholders who lack experience as financial derivatives offers chances of huge rewards and so many attractions even to individual shareholders. However, speculation under derivatives most presumes a great deal of risk consisting commensurate experience and good market idea which favours a small shareholders, this is the purpose why some financial advisers are opposing the use of these instruments. Derivatives are complicated instrument as forms of insurance in transferring risk among a ll parties involve which presume an additional risk. Laker further identified that financial derivatives often have a huge estimated value, as a result of that there is a high level of risk and shareholders might lose much without been compensated. As stated by Berhire Hathaway inc. (2002) on the annual report, that there is a possibility that this could result in a chain reaction and subsequently in an economic crisis. Also Rawles (2006), financial derivatives enormously leverage within the economy, which makes it more complex for the basic real economy to facilitate its debt requirement and restricting the real economic functions which often lead to economic recession. 2.4 THE SUPERVISION OF FINANCIAL DERIVATIVES ANALYSIS The supervision of the financial derivatives should be acknowledged as both the advantage and risk are present in financial derivatives. Though, there few journals which analyse the supervision of financial derivatives, in the late 1990s, Shah (1996), identified that in the rise of huge losses from derivatives dealers and end users in modern years, many issues are being highlighted as regards the regulatory structure that is necessary to supervise and control the use of derivatives, it disagree that the principle in which the issue can be resolved by strict internal policies whereas regulators assume it is necessary for more precise oversight is misplaced though it still can be use for hedging, Derivatives involves high risk technology which often pose problems for regulations and its functions. Recently, Kern (2001), identified that the global regulation of financial markets became obvious in the 1970s with regards to post Bretton Woods liberalisation of financial markets. The removal of the fixed exchange rate equal the outcome of gold in the privatisation of finance risk, which established tension to eliminate the functions of cross border capital movements and more deregulation of the financial market. However, there is need for general regulatory body to build safe and reliable financial institutions such as bank through an efficient management as systemic risk in general market. Also it is necessary for international standards of supervision to also be acknowledged to avoid solvent in the financial institutions in one jurisdiction from the business to collapse to a less reputable institutions functioning in other jurisdictions whose rules only allowed cut rate financial services and more risky financial functions. The privatization of financial risk leads to establishm ent of financial institutions to blow out their risks over to many resources and functions which lead to an important rise in short term cross border portfolio asset which could reveal capital importing nation to increase system risk which was cause by volatility of such investments. Gilnen Tabak (2007) establish a new substitute for gathering information on risks that exists in financial institutions which assist in analysing the risk tools which are found in risk management. This method assists risk managers, supervisors in analysing the potential risk in financial institutions because of derivatives position. The main idea is the linear financial instrument which is also refer to the traditional method often used by management risk system it assist in decreasing roles in risk factors and defend the responsibilities of financial derivatives while the non-linear instrument have roles with different options which are represented as clear as European options. The study shows the propose method captured the risk occurrence in policies that consists of options with an accepted error margin. CHAPTER 3 DATA ANALYSIS AND METHODOLOGY 3.1 CASE STUDY The case study of this research will be the Chinas financial market; this research analysis will focus on the Chinas financial market, together with growth of the socialist market of the real economic structure. Chinas financial market is growing with the ongoing exploration. Currently, Chinas financial Market is essentially established as a pure division of the financial system. Chinas financial Market has started forming and many financial commercial have been developed, this includes Bonds, Stock and commercial bills. The capital loan and a bargain securities markets were established steadily after 1985. During the 1988, treasury bonds were established in the transfer market in major and average cities in china. In 1990 shanghai stock exchange was created and 1991 Shenzhen stock exchange was also created. Both stock exchange in 1999, release 98 A shares and 117 subsidiary shares, increasing 87.7 billion Yuan, which increase the total number of companies listed to 976; the aggregat e increase in foreign capital is about US$610Million with the use of issuing B and H shares. China releases 1.5Billion Yuan of A shares which can be transferred into bonds. In 1994, 94.1 billion Yuan was realised from issuing and selling stocks. The level of the transaction in the stock exchange by 1999 surpass 5,000 billion Yuan and it was summed up to about 401.5billion Yuan which was the value of government bonds issued and 191.1 billion Yuan was government bonds value in cash. This fund has successfully improved the financial status of the listed companies and a rise in the sources of money for technological transformation of the public banks and financial markets. In the recent years, the financial market in China has been undergoing a rapid growth, Neftci and Yuan, Michelle (2006), stated that China financial markets shows about $2 trillion and are anticipating the market to grow to about $10trillion by 2008, the china financial market continues to expand its investment with a view to ensure that their operations are successful. 3.2 RESEARCH AND DATA COLLECTION They are different types of financial derivatives found in Chinas financial market which are vital for the growth of Chinas financial market. The use of the financial derivatives has led to many financial difficulties in the rapid growth of the financial system, there is need for regulators to be more effective and implement more laws on the supervision of the financial derivatives. This will help to determine and regulate the stability of both the China financial market and the supervision of financial derivatives in china. Classic materials similar to the financial market and financial derivatives in China will be use as a guide. Other source of materials will be from the internet, textbooks and journals. This research work is structure to determine the supervision of the financial derivatives in China. The China financial market is chosen as a case for the analysis. The source of the main data is from China, National Statistics of China; and few of the firms annual report will be used for the data analysis. This research work will focus on the nature of the Chinas financial market and the outcome of the financial derivatives in China and the supervision structure of the financial derivatives in China. The SLEPT (refer to Social factor, Legal factor, Economic factor, Political factor, Technological factor) method will be used to examine the general system of the China financial market, it will focus on the classic findings of financial derivatives and also on China financial system in order to examine the nature of the financial market in China. From the results, the research will be based on the nature of the financial derivatives in China to examine the impact, introduction, growth, transactions and practise of the financial derivatives on the Chinas financial market. This research will also examine the supervision of financial derivatives in Chinas financial market in agreement with related articles and also to make some recommendation on the supervision of the financial derivatives in China. 3.3 DATA ANALYSIS The qualitative and quantitative method is both used to analyze the data. Under the qualitative analysis method, the materials such as journals and all information gathered from the internet are related to Chinas financial market and the supervision of financial derivatives, the report of the classic financial organisation will all be gathered as part of the qualitative assistance to the analysis. Some major dialogue by the classic economist in China will also be the main issues for the qualitative analysis; this is due to lack of interviews by government officials and financial managers of most firms. Generally, the secondary materials used will be part of the quantitative analysis, which will certainly show the problem of this research. The quantitative method, this method of analysis is the data and information gathered from different firms. The most significant data is gathered from the China National Statistics. Other information and data are gathered from various reports from different firms. It is difficult to make a questionnaire with this research because the research problem is comprehensive. The major source of information and data are gathered from the internet and few reports from the government is the main structure for the quantitative analysis. The major limitations are the quantitative method in this research is the lack of an individuals observations and analysis on financial markets and the supervision of the financial derivatives. CHAPTER 4 SUMMARY OF FINDINGS 4.1 CLASSICAL FINANCIAL DERIVATIVES USED IN CHINA China has commissioned a model in financial future exchange in 1990s. Ba Shusong (2006), stated that the core financial derivatives are the foreign exchange futures, stock index futures, warrants, convertible bonds and national debt future. Few of the do not function any more, although model is not so successful, it was importance for a lot of valuable experiences. However, with the growth in China financial market, the financial derivatives perform well and will return to China financial market and a fresh product which correspond to the requirements of the growth of economy; this will be additional expansion and will certainly play a vital role in the Chinas financial market. Foreign Exchange futures; Gregory (1995) stated that inside the foreign exchange market, each price in a market is a relative price, which shows an equal rate. In the late 1980s and from the beginning of 1990s, China was completely accommodating for financial derivatives and control method of suitable opened. From 1984, the local enterprises and companies can trade the offshore foreign exchange futures via the stock broking company. This will assist in requirement for hedging of local banks corporations and swap the foreign exchange role. The first ever foreign exchange swap of China exchange market was commissioned June 1992 in shanghai. The transaction in the foreign exchange futures in local have been displayed and developed from time to time. Later on, the Shenzhen foreign exchange centre was due for approval of foreign exchange futures transactions. (Ma Qingquan 2003). Ma Qingquan (2003), later on access the inner and external foreign exchange future and realize that they all have some difficulties which enable the government of Chinese to take a bold step to resolve and restructure the foreign exchange market. From 1993 to 1995, during this era, the Chinese government has continuously ordered the closure of unlawful foreign exchange futures brokerage firms. All the local foreign exchange in China did not operate extensively due to absence of regulators which lead to failure of the implementation. National debt futures; the national debt future is another method of interest rate futures; it is after the most growth of financial futures in China. The national debt future was originally found December 1992 in china. The shanghai stock exchange commission was the first contact of national debt future. In the year 1993, the transaction scope of the general debt futures had been worn out mainly, the individuals and brokers was given access to the market. The Beijing commodity exchange also welcomes the transaction of national debt futures. However, the national debt future was unripe for development; this follows the 314 contract irregularities storm in Shanghai stock exchange in Sept 1994 and 327 contract irregularities storm in February 1995 also emerge. May 1995, concluded the transaction of national debt future which finally collapse. Convertible Bonds; Convertible bonds are part of growing process of the growth of Chinas Stock market. Basically convertible bonds have a slight resemblance with stock options. (A stock option is also known as executive stock options). Little (2008) refer to a convertible bond is a kind of bond that can be switch into shares, bonds in an issuing firm. Mostly a few pre-announced proportion which is hybrid safety with same debt and equity characteristics. Ba Shusong (2006), the convertible bonds have experienced and discovered in over a decade since its first implementation in China, they have been known with many groups and they continue to progress and grow since the growth of the recent social economy of China. The convertible bonds are financial derivatives which agree with state of the growth of China economy. It will grow more and further along with the growth of the Chinas financial market. Warrant, this is a type of derivative protection that gives the owner the ability to buy security direct from the issuer at a given price within a specific period. Warrant are mostly part in a fresh issue which is refer to sweetener this is just to attract the shareholder. Between 1992 to 1996, China has commissioned a lot of warrants, which include sock warrant La Dai Fei, others are Ba oan 93 and Fuzhou East in Shanghai stock market while others warrant was also commissioned in Shenzhen stock market. This include Gui Liugong, Xia Haifa, Min minding, Xiang Zhongyi. However, because of the uncontrolled speculation of warrants, there are important speculations in the drop prices of warrants. The operations of the warrants were dismissed by the national regulatory body in June 1996. The reason for the dismissed is due to absence of regulators of the financial derivative. Hence, it is observed that the supervision and regulation on all types of Financial derivative is very important tha n the operation of the financial derivative. As soon as financial derivatives is in operation there is need for government to present a supervision in order to regulate the operations and function of financial derivatives therefore the financial derivatives will grow with health except if it will be dismissed at the closing stages due to the disorder of the financial market. In conjunction with the reform of the part construct of warrants, the issue of the warrants were present in the outline again. This is due to bearish and bullish choices with the features of the warrants. It has been an efficient way in the movement for safety of the interests of investors and simultaneously, it leads to rise in flexible payment of the price of the movement of non-investors. According to Xu Peng (2007) since 2007, 27 warrants have been registered in shanghai and Shenzhen stock market. Stock Index Futures; In March 1993, stock index futures surfaced in Chinas Hainan securities and exchange center, which showed as Shenzhen composite index and Shenzhen A share index. This is in line with the global practise, such as creation of deposit system. Unfortunately, stock market was not huge enough; the trading activities stopped functioning in the same 1993 due to speculation inside the market. Ba shusong (2006) further stated that 14years after, (April 2007), After the official commissioning of the Future Exchange Management Regulations, the stock index futures has reverted given that it has been compelled to shut down 14years earlier. This revert will certainly become an important discussion for everyone and local institutions. 4.2 STANDARD SUPERVISION OF FINANCIAL DERIVATIVES USED IN CHINA The standard supervision of financial derivatives in China can be categorise into 3, namely, the Risk management, this is the major body of the supervision of financial derivatives, the core regulator of the financial market which is a vital way to regulate the financial derivatives and the creation of rules for financial derivatives which is protection for the supervision of the financial derivatives. 4.2.1 RISK MANAGEMENT This involve the risk management of the market, the risk management of credit, risk management of liquidity, risk management of operation and legal risk management. Risk management of market; this is refer to as the loss in the rise and fall of interest rates, exchange rate and stock prices. Market risk management shows the status of a bank in a market in order to grow the number of frequency and times of the market estimation. Lu wendao (2007), refer this technique of market risk appraisal used in China financial market is to compute the potential of changes in the market price, the exposure of risk and to grow contingency policies in order to enable the right of assessment and to accept the changes in the market. Risk management of credit; The risk management of credit failure is to implement derivatives agreements or breach of contract of financial derivatives credit risk which means when the financial institutions such as banks decide to emulate a transaction which is in agreement with certain regulations. It is recommended that bank should focus more on risk diversification rather than avoiding more concentration of transactions. The risk management of liquidity; Xu and Peng (2007), management of liquidity risk is t