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A Study of the relationship between Basel III regulations and volatility and pricing of financial derivatives

Introduction

The following proposal looks to determine the relationship between the Basel III regulations and volatility within the pricing of financial derivatives. The recent financial crisis highlighted the risks involved in the banking sector, especially with some banks becoming ‘overleveraged’. The regulation was designed to strengthen bank capital requirements by increasing bank liquidity and decreasing bank leverage. Essentially, like Basel I and II, the regulation was designed to increase the level of capital reserves that a bank should keep for certain level of reserves (Repullo, 2011). Basel I and II where originally designed to ensure that banks had sufficient capital to deal with losses stemming from the financial crisis, while Basel III ensured that banks had sufficient capital to deal with a ‘run’ on the bank; something which was seen in the UK with Northern Rock.

Given this, the regulation also puts a focus on the risk exposures within the banking system, ensuring that banks have the high-quality capital to bank up any leverage (Allen et al, 2012). It can be noted that this potentially increases the risks that are associated with such assets; and so impacts on the pricing. This could be seen both in the current price of the asset, as well as the price of any financial derivative which may track it. A financial derivative is a contract that derives its price from an underlying asset, so an equity, interest rate or commodity etc.

Derivatives are used for a number of purposes, insuring against price movements (hedging) as well as increasing exposure to price movements (speculation) (Lee, 2004). While research from Bingham (2013) praised the use of derivatives as a management tool designed to increase certainty, others such as (Levine, 2012; Bryan et al, 2012) critiqued them, blaming them for the downfall of companies such as Enron and Lehman Brothers.

Pricing Financial Derivatives

When it comes to pricing the underlying asset, research from (Hammoudeh, 2013; Hirsa, 2013) have all noted a relationship between risk and return. For instance, in equity pricing, it is noted by – that the price is not only determined by the underlying assets in the business, but also down to the potential return of the business for the investor. The underlying assumption here is that the higher the risk, the higher the expected return (Bodie, 2013). This will also be seen within the pricing of the financial derivative, given that the price of the derivative would be derived from the price of the underlying asset, but also derive from the potential volatility associated with the asset. So, a riskier asset could be seen as more volatile, which according to Titman et al (2015) could have an impact on the pricing of the financial derivative.

Other researchers also mention the factor of time and risk, with longer-term derivatives carrying higher risks given the longer timescale from prices to change. Research from the likes of Titman (2014) have all focused on the pricing of these financial derivatives, noting the Black Scholes Model. The model takes a number of variables into consideration, namely the current underlying price of the asset, the ‘strike’ price of the option, time until expiration, implied volatility and the risk free rate. Figure 1 below provides an example of the Black Scholes model when it comes to pricing a call option:

Picture1

Figure 1 – Obtained from http://www.investopedia.com/university/options-pricing/black-scholes-model.asp

These derivatives enable parties to trade specific amounts of an asset, be it a commodity, stock or currency. This can be undertaken for trading, arbitrage opportunities between markets or risk management among others. Essentially, the writer of the contract is paid a fee. When it comes to the exchange date, the buyer has the option to use or leave the derivative, which in turn would be based on the actual spot price versus the contract price.

Derivatives can also be noted in terms of interest rates. For instance, a ‘plain vanilla interest-rate swap’ is the most basic type of interest-rate derivative. Under this agreement two parties are involved. Party one receives a stream of interest payments based on a floating interest rate and pays a stream of interest payments based on a fixed rate. On the other side, party two receives a stream of fixed interest rate payments and pays a stream of floating interest rate payments. Both streams of interest payments are based on the same amount of notional principal. Changes in the floating interest rate will essentially create a winner and a loser (Chen, 2012). The receiver of the fixed payment may be doing such to guarantee a certain payment (risk management), while the receiver of the floating payment may be taking a bet that that floating rate will increase past the fixed.

Basel III – Implications

Before Basel III was introduced into the market there were a number of studies looking to determine the potential impacts that such regulation would have on the market. KPMG (2011) noted that the requirement to increase ‘buffers’ within the banking industry would in turn reduce the lending capacity within the financial system. Furthermore, there will also be significant pressure placed on the backs profitability and ROE, decreasing investor returns associated with the bank.

However, when it comes to the impact on financial derivatives, a chain of events could be considered. To start, banks may look to reduce their exposure to riskier businesses lines, in particular into investment banking operations such as trading. McKinsey (2010) noted that a number of large banks have already looked to sell on some of their investment banking operations; or cut down the scale to focus on the consumer/ business side. Commentary from E&Y (2011) noted that this has been down to a risk-cutting exercise, with larger banks looking to reassure customers over the safety. Basel III will also increase the Risk-Weighted Asset requirements for banks, essentially putting pressure on banks to provide adequate reserves to meet the risks associated to trading etc (shown below).

Picture2

Figure 2 – Basel III will see increasing requirements – https://www.pwc.com/us/en/financial-services/publications/viewpoints/assets/viewpoint-basel-iii.pdf

At the same time it could also be noted that any increase in the reserve ratio at banks will prompt higher competition among the banking sector for deposits from the consumer. This in turn may prompt banks to offer higher rates when it comes to savings. The change here is that the savings rate offered by banks could be seen as the risk-free rate; as so any increases in the risk-free rate would impact on the pricing of financial derivatives. Ultimately, investors will demand a higher return from riskier assets as the return on the risk-free asset increases; i.e. holding money in a bank.

Volatility and Speculation

When it comes to volatility in pricing, it could be noted that research from Chance (2015) links volatility within the financial markets to demand for such assets, meaning that these derivatives can be traded multiple times in a short-space of time. Speculation is the issue here. One recent example could be seen on the Dalian Commodity Exchange in China, where the price of steel surged after interest in future contracts. According to one report, these contracts were changing ownership every 4 hours, showing that it was investor speculation, rather than actual demand driving the price increase (Lian, 2016). Lian (2016) notes that situations like this are when risks rise, especially when the price of the financial derivative seems to diverge away from the actual current price or economic fundamentals.

The link here with the Basel III regulation is that banks are now exiting their derivatives businesses in a bid to remove the risks associated from their business models. Over recent years banks such as Barclays, Morgan Stanley and RBS are just some that have reduced their exposure to such trading activity. Removing more ‘players’ from the market potentially reduces the level of transactions associated with financial derivatives, in turn reducing the volatility of such instruments.

Derivatives Still Widely Used

However, while some banks are retreating from derivative trading, others are expanding their presence as derivatives remain a useful form of hedging for many businesses. As mentioned above, derivatives could be used for stocks, commodities, currencies and even interest rates (Brigham, 2013). Many businesses now routinely hedge their currency rates, their interest rates or their commodity prices through such tools in a bid to increase the certainty of such costs and also improve their own risk management (Bodie, 2013).

Given this, there is some hesitation from the researcher that the introduction of the Basel III regulation may have little impact on the pricing of financial derivatives given that as the more mainstream banks move away from the industry, a new wave of boutique banks enter the market, ensuring that such financial derivatives are still available to the market. However, while the derivatives may still be available, there is the potential for the price of such to increase as banks price in more risk to the investment. Essentially, the bank (or the writer) of the derivative is essentially making a bet; a bet which they will win if the buyer decides to leave the contract untouched; netting the writer the premium as a profit. However, if the buyer decides to use the derivative, maybe because the commodity price has risen higher than the strike price, then the writer essentially loses out as they have to provide the asset at a price lower than the current market (Dorfman, 2012).

Proposed Methodology

The study will look to consider historical time series data relating to financial derivative prices; using the time series to consider any changes in the market since the 1 January 2013 adoption of Basel III. The quantitative data can be obtained from platforms such as Bloomberg and Thomson Reuters, easily downloaded into an Excel for analysis. This can then be compared against the timeframe of the Basel III regulation, looking to see any relationships.

Data will be collected on a number of pre-determined financial derivatives; essentially time series. As well as collecting data on the price, data will also be collected on the volume of transactions related to the financial derivative. This is due to the hypothesis which has been determined from the literature review above. Essentially, the researcher believes that the volume of transactions may have fallen given banks exiting the business, reducing volatility in the process; while prices may also been affected as the perceived risk of holding such derivatives increases.

The project is designed to be undertaken over a 3-year period, given the researcher the ability to constantly monitor these factors up to the 1 January 2019 deadline when new rules must be met. The benefit behind this is that the researcher does not expect a change in the derivatives market overnight. Instead, it is expected to be a continual process, driven by banks exiting the derivatives markets and the perceived risks of such instruments. What the researcher hopes is that a relationship can be identified over the period; and that a change will be seen in pricing between 2016 and 2019.

Concluding Remarks

The researcher hypothesises that the introduction of Basel III regulation will impact onto the financial derivatives market. Given the specifics of the regulation, it is believed that mainstream banks will look to exit derivatives trading given tough new regulation on financial reserves to buffer against a ‘run’ on the bank. Given this, it would be expected that the risks associated with financial derivatives would increase, leading investors, or in this case the ‘writers’ to demand a higher rate of return, potentially increasing the cost of such instruments. To show this, the researcher will undertake a time series study, using financial information from Bloomberg and Thomson Reuters to collect the price/ volume of financial derivatives traded over the current/ historical period.

 References

Allen, B., Chan, K. K., Milne, A., and Thomas, S. (2012). Basel III: Is the cure worse than the disease?. International Review of Financial Analysis, 25, pp.159-166.

Bingham, N. H., and Kiesel, R. (2013). Risk-neutral valuation: Pricing and hedging of financial derivatives, London, Springer Science & Business Media.

Bodie, Z. (2013). Investments, New York, McGraw-Hill.

Brigham, E., and Ehrhardt, M. (2013). Financial management: Theory & practice., London, Cengage Learning.

Bryan, D., Martin, R., Montgomerie, J., and Williams, K. (2012). An important failure: knowledge limits and the financial crisis. Economy and Society, 41(3), pp.299-315.

Chance, D., and Brooks, R. (2015). Introduction to derivatives and risk management, London, Cengage Learning.

Chen, L. (2012). Interest rate dynamics, derivatives pricing, and risk management (Vol. 435), London, Springer Science & Business Media.

Dorfman, M. S., and Cather, D. (2012). Introduction to risk management and insurance, London, Pearson Higher Ed.

E&Y. (2011). Basel III liquidity requirements and implications, London, E&Y Research.

Hammoudeh, S., and McAleer, M. (2013). Risk management and financial derivatives: An overview. The North American Journal of Economics and Finance, 25, pp.109-115.

Hirsa, A., and Neftci, S. N. (2013). An introduction to the mathematics of financial derivatives, London, Academic Press.

KPMG. (2011). Basel III: Issues and Implications, London, KPMG.

Lee, B. (2004). Financial derivatives and the globalization of risk, U.S.A, Duke University Press.

Levine, R. (2012). The governance of financial regulation: reform lessons from the recent crisis. International Review of Finance, 12(1), pp.39-56.

Lian, R., and Serapio, M. (2016) [Online]. China commodity exchanges crack down on speculation as rebar volumes soar, Available at http://www.reuters.com/article/us-china-commodities-futures-idUSKCN0XJ0TP [Accessed 22 May 2016]

McKinsey. (2011). Basel III and European banking: Its impact, how banks might respond, and the challenges of implementation, London, McKinsey.

PWC. (2010). The New Basel III Framework: Navigating Changes in Bank Capital Management, London, PWC Research.

Repullo, R., and Saurina Salas, J. (2011). The countercyclical capital buffer of Basel III: A critical assessment, CEPR Discussion Paper.

Titman, S., and Martin, J. D. (2014). Valuation, London, Pearson Higher Ed.

Titman, S., Martin, J. D., and Keown, A. J. (2015). Financial management: Principles and applications, London, Prentice Hall.