The Asian Financial Crises: The Role of Derivative Securities Trading and Foreign Investors

Abstract

This paper is part of a larger research program pertaining to the role of derivatives during financial crisis and also part of the research pertaining to the causes of the Asian financial crisis. The Korean market is studied because of two reasons: (1) it is a representative example of the Asian financial meltdown and (2) there is a detailed data set available of all transactions by different types of protagonists, including foreign investors. Several authors including Kim and Wei (1999), Park and Song (1999) and Radelet and Sachs (1998) put the blame for the Asian crisis on foreign investors. Choe, Kho and Stulz (1999), who focused exclusively on equity trading in the Korean stock market, found no evidence supporting market de-stabilization by foreign investors during the crisis. They did not find any evidence showing that the foreign investors' herding is more important and they engaged in positive feedback trading during the crisis. They also found no evidence that foreign investors de-stabilized the stock market in event studies that examined the abnormal returns centered around large trades by foreign market participants. The paper begins with establishing first the role of derivative securities during the crisis. None of the studies so far have examined futures trading. Our paper focuses on this largely overlooked and important feature of the crisis. Once the role of futures contracts is understood, the paper complements Choe et al.'s analysis by examining whether derivatives trading by either domestic or non-resident investors, or both together, exerted a de-stabilizing influence during the crash. The results in this paper indicate that futures market played a key role during the Korean stock market turbulence in 1997. We find that the fraction of index futures volume started to rise dramatically in July 1997, three months ahead of the crash, and died out after the crash. Furthermore, we also report that selling pressures in the futures market during the crisis were transmitted to the cash market causing a decline in cash prices, a pattern which was not observed prior to the crisis. Given the significance of futures trading, we examine whether futures trading by either domestic or foreign investors, or both together, exerted a de-stabilizing influence during the crisis. We find that foreign investors increased their presence in the futures market and dramatically increase their herding of futures trading. Foreign traders also become negative feedback traders of futures and the permanent impact of their futures contracts sales increases substantially during the crisis.