Complex Financial Instruments Research Articles

The Evolution of Futures and Options Markets: From Agricultural Roots to High-Frequency Trading

The evolution of futures and options markets from simple agricultural hedging tools to complex financial instruments has been marked by significant technological advancements, particularly the advent of electronic trading and high-frequency trading (HFT). This paper traces the development of these markets, highlighting key milestones and innovations that have shaped their current form. High-frequency trading, while enhancing liquidity and reducing transaction costs, has also introduced significant challenges, including increased market volatility, the potential for market manipulation, and systemic risks, as seen in events like the 2010 Flash Crash. This research provides a comprehensive analysis of the legal and regulatory frameworks governing futures and options markets, with a focus on both Indian and international contexts. It examines the effectiveness of existing regulations in addressing the challenges posed by modern trading practices and explores the need for continuous adaptation in regulatory approaches. Through a detailed review of relevant case laws, statutory provisions, and scholarly literature, the paper identifies gaps in current regulatory practices and proposes recommendations to enhance market transparency, fairness, and stability. The study concludes that while the evolution of futures and options markets has brought undeniable benefits in terms of efficiency and risk management, these markets must be carefully regulated to mitigate the risks associated with high-frequency and algorithmic trading. Adaptive regulatory frameworks, enhanced transparency measures, and international cooperation are essential for ensuring that these markets continue to contribute positively to the global financial system.

Financial innovation intra Muslim capital markets and inter global counterparts: implications of differences

Purpose This study aims to investigate the implications for financial innovation and product development of differences between schools of jurisprudence (fiqh) pertaining across regional Muslim markets, and the consequences for global financial institutions. Design/methodology/approach The methodology is qualitative, drawing upon several sources. Firstly, differences in interpretation regarding the economic and moral responsibilities of financial institutions in Islamic and secular contexts. Secondly, contrasting tenets of schools of Islamic jurisprudence regarding the permissibility of products traded intra Muslim markets. Thirdly, characteristics of complex financial instruments traded in global secular markets prior to the credit crisis of 2007–2008. Findings Differences between Islamic and global secular interpretations regarding responsibilities of financial institutions militate against integrated markets across which products can be seamlessly traded. Global financial institutions should recognise that different Islamic schools of jurisprudence prioritise either legal form or substance of financial products, but not both simultaneously. This should be considered when designing new products for regional Muslim markets. Practical implications Global financial institutions which focus upon the legal (micro) form of new Islamic products should relate in investor prospectuses and marketing materials the extent to which these accommodate Islamic jurisprudence’s equal (macro) concern for public interest or maslahah. This may comprise the reallocation of risk from those unable to bear it to those willing to assume it for a price, reinforcing rather than compromising economic stability. Originality/value This study evaluates implications for product development and marketing for global financial institutions active in regional Muslim markets across which different Islamic schools of jurisprudence apply.

Analysing the Factors Behind Exchange Rate Fluctuations in India

Abstract: The study gives an overview of the various determinants of the exchange rate movements in India. Out of the multiple factors affecting the Rupee-Dollar value the impact of Interest rate differential, Trade deficit of India, Foreign Net investment inflows to India, Oil prices, and Gold prices (in the short term) on the exchange rate has been studied using Regression analysis and correlation and the role they played by the above mentioned variables in determining the exchange rate during the Global Financial Crisis of 2008-2010 and during the Covid-19 Period from 2020-2023. Exchange rate fluctuations play a crucial role in shaping the economy of a country, and India is no exception. The exchange rate of the Indian rupee against major world currencies is subject to constant fluctuations, influenced by a multitude of domestic and global factors. These fluctuations have significant implications for various stakeholders, including businesses, consumers, investors, and policymakers. Several factors contribute to the exchange rate fluctuations in India. One of the primary factors is the demand and supply dynamics of foreign exchange. Factors such as trade balance, foreign direct investments, portfolio investments, remittances impact the demand for and supply of foreign currency, Crude oil prices, Gold prices, and thereby affecting the exchange rate. In addition, macroeconomic variables like inflation, interest rates, and economic growth also play a crucial role in determining exchange rate movements. For instance, a high inflation rate in India compared to trading partner countries can lead to a depreciation of the rupee. Global economic conditions and geopolitical events are other significant factors influencing exchange rate fluctuations in India. Economic developments in major trading partners, changes in global commodity prices, and geopolitical tensions can all impact investor sentiment and capital flows, leading to fluctuations in the exchange rate. For example, uncertainties related to Brexit or trade tensions between major economies can trigger volatility in currency markets. Monetary policy decisions by the Reserve Bank of India (RBI) also play a crucial role in influencing exchange rates. Interest rate changes, open market operations, and forex interventions by the central bank can impact the value of the rupee visa-vis other currencies. The RBI often intervenes in the foreign exchange market to stabilize the rupee or prevent extreme volatility. Apart from these factors, market speculation, investor sentiment, and technological advancements in the financial markets can also contribute to exchange rate fluctuations. High-frequency trading, algorithmic trading, and the use of complex financial instruments by market participants can amplify exchange rate movements and increase volatility

A Qualitative Analysis on the Role of Auditors in Preventing Financial Crises

This study investigates the pivotal role of auditors in mitigating risks associated with financial crises, focusing on risk assessment, internal control evaluation, and addressing complexities in financial instruments. Employing a qualitative research approach, data was gathered through comprehensive literature review and thematic analysis. Findings underscore auditors' significance as guardians of financial integrity, detecting errors, and fraud in financial statements, thus enhancing transparency and investor confidence. Moreover, auditors' assessment of internal controls aids in fraud prevention and compliance risk management, crucial for organizational resilience. Challenges in evaluating complex financial instruments highlight the need for specialized expertise and technological advancements. The study emphasizes interdisciplinary collaboration, continuous professional development, and adherence to ethical standards as essential strategies for auditors to navigate emerging risks effectively. Overall, the research contributes to understanding auditors' multifaceted role in preventing financial crises and underscores the importance of robust risk assessment practices in maintaining financial stability.

The audit of banks in the USA: Has it changed since the financial crisis?

AbstractThe most recent financial crisis exposed to the auditors the risk associated with the audit engagement of their banking clients. Because many banking clients failed and investors suffered trillions of dollars in losses, auditors are now defendants in numerous shareholder and regulatory lawsuits. There is consensus that the financial crisis was created by an abundance of credit, excessive risk taking through complex financial instruments, weak corporate structures, and ineffective regulatory mechanisms. In this study, we examine how the financial crisis has affected the audit engagements of banking clients. We examine audit fees, audit report lag, and auditor changes before and after the financial crisis with respect to specific bank risks like credit risk, interest rate risk, and liquidity. Overall, we find that auditors are more responsive to bank risks in the post-financial crisis period compared to the pre-financial crisis period.

A Critical Analysis of Risk Auditing: An Auditor's Approach

This research aims to critically analyze risk auditing, focusing on the auditor's approach, to uncover complexities and challenges inherent in contemporary auditing practices. The study synthesizes findings from a literature review, discussing implications for auditors, organizations, and future research. The multifaceted role of auditors in risk auditing involves identifying, assessing, and managing risks across financial and operational domains, ensuring organizational objectives and assets' safeguarding. Auditors must possess diverse skills, expertise, and judgment to navigate subjective risk assessment, particularly in evaluating emerging risks and complex financial instruments. Moreover, auditors must adopt a proactive approach to risk management, anticipating potential risks and providing timely recommendations. However, challenges such as the lack of standardized risk assessment practices, the rapid pace of business environment changes, and integrating emerging technologies into risk auditing persist. These challenges underscore the need for ongoing innovation and improvement in risk auditing practices. Empirical findings suggest a positive association between risk disclosures' quality and firm performance, emphasizing governance mechanisms' importance in risk management. By addressing challenges and collaborating with stakeholders, auditors can enhance risk management practices' effectiveness, safeguarding organizational objectives and assets in dynamic business environments.

Finance and biodiversity conservation: insights from rhinoceros conservation and the first wildlife conservation bond

AbstractThe Rhino Bond is the first financial instrument dedicated to protecting a species. The Bond allows investors to invest in the conservation of the black rhinoceros Diceros bicornis, with the amount of money returned by the investment depending on whether rhinoceros numbers increase (and by how much). In this paper we focus on how the Bond was brought into being. We draw on an analysis of organizational reports along with data collected from interviews with key informants to investigate the roles of the various stakeholders in the Bond, how species and sites were selected, the motivations and experiences of the stakeholders and the involvement of stakeholders in decision-making. We found that although conservation actors are attracted by the potential for new funding, they have experienced challenges navigating complex financial instruments. The needs of financial actors often dictated decision-making, with implications for the species and sites chosen for the Bond. As profits are tied to an increase in population size of a specific species (which needs to be monitored), the instrument has favoured large and easily counted species and populations. Only some sites were able to meet the stringent conditions of financial instruments, including metrics on financial sustainability. We argue that the dominance of financial principles and motives means that not all species or sites will be viable candidates for investment and that conservation finance should not be seen as a panacea.

A Critical Analysis of Risk Auditing: An Auditor's Approach

analyze risk auditing, focusing on the auditor's approach, to uncover complexities and challenges inherent in contemporary auditing practices. The study synthesizes findings from a literature review, discussing implications for auditors, organizations, and future research. The multifaceted role of auditors in risk auditing involves identifying, assessing, and managing risks across financial and operational domains, ensuring organizational objectives and assets' safeguarding. Auditors must possess diverse skills, expertise, and judgment to navigate subjective risk assessment, particularly in evaluating emerging risks and complex financial instruments. Moreover, auditors must adopt a proactive approach to risk management, anticipating potential risks and providing timely recommendations. However, challenges such as the lack of standardized risk assessment practices, the rapid pace of business environment changes, and integrating emerging technologies into risk auditing persist. These challenges underscore the need for ongoing innovation and improvement in risk auditing practices. Empirical findings suggest a positive association between risk disclosures' quality and firm performance, emphasizing governance mechanisms' importance in risk management. By addressing challenges and collaborating with stakeholders, auditors can enhance risk management practices' effectiveness, safeguarding organizational objectives and assets in dynamic business environments.

Cross-impact in Derivative Markets

Trading a financial asset pushes its price as well as the prices of other assets, a phenomenon known as cross-impact. The empirical estimation of this effect on complex financial instruments, such as derivatives, is an open problem, tackled in this issue�s cover article �Cross-impact in Derivative Markets� by Michael Benzaquen, Mehdi Tomas and Iacopo Mastromatteo. To address this, the authors consider a setting in which the prices of derivatives is a deterministic function of stochastic factors where trades on both factors and derivatives induce price impact. Benzaquen, Tomas and Mastromatteo show that a specific cross-impact model satisfies key properties which make its estimation tractable in applications. Using E-Mini futures, European call and put options and VIX futures, the authors estimate cross-impact and show our simple framework successfully captures some of the empirical phenomenology. Benzaquen et al�s framework for estimating cross-impact on derivatives may be used in practice for estimating hedging costs or building liquidity metrics on derivative markets.

Elasticsearch as a NoSQL Database for Fast Distributed Financial Service Applications

This paper explores the implementation of Elasticsearch as a primary data store for fast, distributed financial service applications. It examines the advantages of Elasticsearch in the context of financial services, including its scalability, high performance, flexible schema, and powerful search and analytics capabilities. The study addresses key challenges encountered during implementation, such as eventual consistency, limited join capabilities, and field limits, providing practical solutions based on real-world experience. The paper also discusses implementation strategies, focusing on data modeling for complex financial instruments, query optimization, and performance tuning. By balancing Elasticsearch's strengths against its limitations, this case study demonstrates how financial service organizations can leverage this technology to build more scalable, performant, and adaptable systems capable of handling the increasing data volumes and real-time processing demands of modern finance.

Towards Equal Tax Treatment of Economically Equivalent Financial Instruments: Proposals for Taxing Prepaid Forward Contracts, Equity Swaps, and Certain Contingent Debt Instruments

In recent years, many commentators have debated the merits of various proposals regarding the taxation of financial derivatives. The Internal Revenue Service (the "Service") has, in the case of certain derivatives, attempted to settle that debate by issuing regulations that address the taxation of notional principal contracts and contingent debt instruments. The debate, however, continues, mainly because many financial instruments are economically equivalent to one another and yet give rise to different tax results. Rather than proposing changes in the tax treatment of specific instruments, commentators now call for the complete overhaul of all of the rules governing the taxation of all financial instruments. While many of those proposals certainly have merit, it seems as though the Congress is not likely to completely overhaul the Internal Revenue Code (the "Code") any time soon. A good deal of the debate concerning the taxation of financial derivatives has centered on the corporations that issue these derivatives (the "issuers"). In the author's opinion, many of the problems and abuses cited by those commentators should be solved not by focusing on the issuer, but by focusing on the investor who purchases these derivatives. That conclusion stems from the following four facts: First, issuers develop complex financial instruments such as contingent debt instruments in order to accommodate the demands of investors.5 Second, issuers of complex financial instruments often enter into hedging transactions that leave them in the same position in which they would have been, with respect to both economic result and tax treatment, had they issued traditional fixed or floating rate debt instruments. Third, investors will be taxed differently depending on the type of derivative that they purchase. Fourth, so long as issuers can save money by issuing financial derivatives such as contingent debt instruments, they will continue to do so. Thus, issuers usually design derivatives to save money by accommodating a particular investor profile. In light of that fact, the government should focus its reform efforts on investors.

Price, information and product quality: Explaining index insurance demand in Burkina Faso

Index insurance is a promising avenue for addressing risk in developing countries, but pilot index insurance projects are rarely scaled-up because demand remains disappointingly low. This article studies an area-yield insurance product which generated high demand and sales in Burkina Faso, and was subsequently scaled up nationally. We exploit experimental and quasi-experimental variations to measure and compare the effect of price, information, and product quality on insurance demand. Our results suggest that price has an important effect on demand, while information also plays a role. However, the quasi-experimental variation in product quality across farmer groups does not affect insurance take-up. Demand is much lower during the scale-up, suggesting that implementation efforts during the pilot also matter. These findings show that high quality index insurance products can be attractive for farmers, but that price for value, along with other factors, remain major barriers to adoption. Our results also suggest that small-scale farmers may not fully understand the complex financial instruments offered to them commercially, with implications for the use of index insurance as a policy option to foster resilience.

FINANCIAL DECISION MAKING AMONG YOUNG ADULTS: AN AHP APPROACH

In an uncertain economic environment, the decision-making process regarding personal finances relies heavily on personal experience and behavior, and is largely influenced by a variety of psychological and socio-demographic factors. The aim of this paper is to analyze the key factors of the decision-making process regarding financial choices of the population of young adults in the Republic of North Macedonia, and to further explain young people’s motives for the proposed decision and the conditions under which the decision was made. The research was conducted through an AHP-based questionnaire that was distributed to respondents ranging in age from 18 to 35 years. According to the obtained results, the respondents value financial security the most, hence their primary choice is investment in real estate and commodities. Young adults are less inclined to invest, especially in the more complex financial instruments. The developed AHP model will help young people make better, fact-based financial choices.

The ABCs of EFCs: Eligible Financial Contracts and Energy Company Insolvency Proceedings

Canadian insolvency laws provide special treatment for complex financial instruments such as swaps, forwards, and other derivatives referred to as “eligible financial contracts” or “EFCs.” However, this special treatment continues to lead to disputes during insolvency proceedings as to whether various forms of energy trading contracts are properly characterized as EFCs. This article establishes that courts look at the essence of any contract and whether it serves an underlying financial purpose to determine if it can be characterized as an EFC. This article also aims to clarify the scope and limitations of the protections and legal remedies that may be available or unavailable to solvent counterparties to an EFC.

Matching Risks with Instruments in Development Banks

ABSTRACT This paper explores how development banks should deploy appropriate financial instruments to encourage real economic risk-taking while minimizing financial engineering risks. We distinguish real economic risks from financial engineering or intermediary risks and argue that using complex financial instruments to leverage additional private financing may undermine policy steer and lead to too much risk being taken by development banks. We then explore comparative advantages of different financial instruments such as loans, guarantees, equity, and insurance in tackling risks in normal times. Then we synthesize common features of development banks’ responses to the COVID-19 crisis. Finally, we propose future research directions.

The Impact of Complex Financial Instruments on Banks’ Vulnerability: Empirical Evidence on SSM Banks

Level 2 (L2) and Level 3 (L3) assets and liabilities represent a substantial portion of European banks’ balance sheets, and valuing them is extremely difficult, since no liquid market prices are available. This paper relies on a large panel of euro-area banks between 2014 and 2019, and two different econometric frameworks, in order to estimate the relationship between the holdings of selected instruments (L2, L3 and Non-Performing Loans, NPLs) and banks’ key performance and risk profile metrics, namely Credit Default Swaps (CDSs), Price-to-Book (PtB) ratios and Z-scores. It finds that larger holdings of L2 tend to be associated with higher CDSs, at least in the short run, while larger amounts of NPLs and L3 tend to characterize banks with higher CDSs, lower PtB ratios and worse Z-scores, other things being equal.

Self-placement of Complex Financial Instruments by Banks to Retail Clients and Civil Liability Issues – An Overview of Greek Case-Law

Abstract This study focuses on self-placement of complex financial instruments to retail clients which is often associated with mis-selling practices. Recent case law in Greece concerning distribution Of “Coco” bonds by a Cypriot bank to its clients reveals, on the one hand, the stand Of Greek Courts concerning the interpretation of certain ambiguous MiFID I Conduct of Business (COB) rules and, on the other, their interplay with civil law duties and the intricacies that arise in order to substantiate a civil liability claim for breach of the COB rules, such as the difficulty to prove causation in securities litigation. The study further evaluates the new MiFID II/MiFIR provisions that relate to the practice of self-placement and supports the adoption of a civil liability regime at the EU level, as well as other alternatives to further enhance retail investor protection.

The modeling of forecasting new situations in the dynamics of the economic system on the example of several financial indicators

The problem of "correct" description of the dynamics of stochastic processes is the subject of numerous studies. The article deals with financial and economic indicators as the objects of research. Understanding the dynamics of financial indicators of the world market is becoming more and more relevant due to the growth of complex financial instruments, as well as due to political and economic events in the world. Observations of recent months indicate that a number of events can significantly affect the dynamics of financial indicators and, therefore, new approaches and methods are needed to quickly assess the impact of such events on financial indicators. The article investigates the possibility of predicting the dollar exchange rate against the ruble based on news reports using NLP and machine learning algorithms [1]. It is shown that the model constructed using text analysis is able to assess the trend of movement of the financial indicator. Fractal and statistical analysis of the selected indicators was performed. Time series clustering was performed using topological analysis methods. Neural network models of the indicator of interest are constructed on the basis of all the conducted studies [2]. The analysis of the obtained solutions is carried out.

Valuation Risk: A Holistic Accounting and Prudential Approach

Valuation Risk (VR) is the risk that an entity will experience a loss due to the inaccurate determination of the fair value of the financial instruments on its balance sheet. This risk is particularly significant for financial instruments with complex features, with limited-to-no liquidity, or with valuations that rely on internally developed models that may be seldom verified using actual trades. Bank VR has been drawing international supervisory attention recently. In February, the European Systemic Risk Board warned that the substantial amounts of instruments with complex features and limited liquidity that sit on banks’ balance sheets are a source of risk for the global financial system. In parallel, the European Central Bank has put trading risk and asset valuations among its supervisory priorities for 2020 and said it plans to execute investigations on banks with significant portfolios of complex instruments measured at fair value based on pricing models. Measured in terms of possible losses from fair value calculations and/or estimation errors on capital ratios, the potential impact of VR can be significant for banks with a combination of a high ratio of fair valued assets to total assets and a high leverage ratio. In such cases, even a relatively small error in determining fair values may significantly decrease the Tier 1 ratio. From a business perspective, banks with opaque and incomplete disclosure about the methods used to estimate the fair value (and the variation thereof) of complex financial instruments may find their stock prices penalized by financial analysts. The nature of VR differs from other banking risks. Market and credit risks, for example, are defined in terms of potential losses derived from the uncertainty about instrument prices over time. VR, however, measures uncertainty surrounding the difference between the reported fair value and the “true” tradeable price that a bank could obtain if it were to sell an asset or transfer a liability at a specific point in time (i.e., the valuation date). Prudential and accounting frameworks have designated a set of mitigation measures to deal with VR uncertainty, which are interrelated. We have conducted a comprehensive analysis of bank VR, encompassing governance, regulatory, and prudential dimensions and summarize it in the paper linked below. We describe the VR framework for a bank through a holistic approach, provide a detailed analysis of the relationships between the accounting and the prudential frameworks, and outline a methodological approach for the prudential treatment of VR. We conclude that: 1) Regulators will increasingly challenge banks over their fair value determination practices as part of a supervisory approach that looks for consistency and rigor across the whole valuation process. In this context, banks will face governance challenges on the clarity of the roles and responsibilities for different functions (namely, finance and risk.) 2) The requirements of the current prudential regulatory framework do not ensure that banks build a capital buffer large enough to address VR. Researchers and regulators should undertake additional studies to develop a sound and agreed upon methodology to identify and measure VR. 3) Regulators should require banks to provide more extensive disclosure about their exposure to VR. Increasing clarity and transparency around bank risks will enhance public trust and enable more accurate estimations of the risk embedded in banks’ balance sheets by observers and analysts. This would also be reflected in bank share prices.

Managerial analysis of instruments for raising international financing

Syndicated loans and eurobonds are the major mechanisms for raising international financing. In this article the following types of financial instruments available to Russian corporate borrowers in the syndicated loans and eurobonds markets are considered: bridge loans, revolving credit facilities, terms and pre-export loans, project finance; bonds with one/several tranches, ruble-denominated eurobonds, benchmark and long-term bonds. Syndicated loans and eurobonds are complex financial instruments available for corporations with the following profiles: (1) leading 1st and 2nd tier and companies with a track-record of raising international financing; (2) industry leaders (top-5 by market share) with annual revenue exceeding USD 500 mln; (3) companies with a significant share of export operations and foreign currency revenue that is required for the payment of interest and principal amounts of the loans and bonds; (4) borrowers and issuers with credit ratings from the international rating agencies; (5) companies with audited accounts prepared in accordance with IFRS. The SWOT-analysis of these financial instruments is given, as well as the comparative analysis that includes the following parameters: industry specifics, liquidity, publicity. As part of the comparative analysis the execution schedule for syndicated loans and eurobonds transactions is considered. This schedule includes five stages: preparing the corporation for the transaction, working with banks, the syndication process, drafting the legal documentation, receiving the funds by the firm. The main characteristics of syndicated loans include flexibility of the structure, fast execution process and information confidentiality. This is why a syndicated loan is suitable for quickly raising financing from several key banks of the borrower in the case of an acquisition of another company. As the long-term solution, such loans can be then refinanced by eurobonds. The paper concludes that for the leading corporations the optimal choice between loans and bonds lies in the combined use of these instruments to solve various financial problems.