Discuss how options and futures contracts are used in a market downturn like the
Global Financial Crisis.
A market downturn is a situation where some financial assets lose a large part of their nominal value, causing a general slump in economic activity. The Global Financial Crisis was associated with banking panics, recession, currency crises, sovereign defaults, and stock market crashes (Stafford, p.8). In recession, economic factors such as GDP, employment, investment spending, business profits, and household income fall. Governments may engage in future contracts with its banking institutions in such situations. Subsequently, the government may engage in contracts with its people as well as other governments to pull itself out of a market downturn (Stafford, p.13).
Treasury bonds are some of the options governments use. A bond is a form of a loan, under which the user owes the holders a debt and, depending on the terms of the bond, is obliged to pay them interest or the principal at a later date, and termed as maturity. Bonds are usually issued by governments for short term, medium term, and long term. Short-term bonds mature between one to five years. Medium term bonds mature between six to twelve years, and long-term bonds mature for periods longer than twelve years. Bonds that mature for a period of less than one year are called Money Market Instruments (Ross, 17).
Money market bonds are usually issued by insurance companies. However, banks have also started venturing into this option. Financial institutions and governments use this option to enable them to continue trading, or finance a project that is yet to be completed. Since the economy is in a slump, money circulation is low therefore the need for borrowing (Stafford, p.19).
Treasury bills are also other forms of future contracts issued by governments only. They do not pay interest; instead, they sell at a discount of the par value, to create a positive maturity (Stafford, p.19). These bills usually last for less than one year. Governments use such options during investment spending, to stimulate infrastructural growth in the country.
Mortgages can be considered as a future contract between a bank and a client. Case scenario being Australia, residential mortgages are used as securities by banks. A mortgage is a contract between an individual intending to purchase an asset, like a house, and a financial institution. The individual commits himself/herself to paying a certain amount of money monthly to the financial institution (Ross, p.25). Using this expected cash flow, financial markets are able to speculate their income therefore plan on how to survive a market slump. These mortgages can also act as instruments of trading between financial institutions, which opt to but some of the mortgage from other banks. This option has a high return on asset, because when the client defaults on payment, the asset is re-acquired by the financial institution.
Still focusing on Australia, during the 2008 Global Financial crisis, the federal government opted to buy the Residential Mortgage Backed Securities from its financial institutions to enable it keep operating. Australia bought these securities through the Australia Office of Financial Management (Ross, p.33).
An option that is used by governments to its big businesses and institutions is a financial bailout. This involves the government giving a loan to the indebted amount the institution is in. Governments can also seek for bailouts from larger trade bodies. Cyprus and other European Union countries sought bailouts from the European Union.
The last and worst option for a government, is tapping into the savings of its citizens. This lowers the household income, and affects the people livelihoods negatively. This is because it is not a debt, but an obligation by the citizens to its government to give it money, without the possibility of being refunded. These various features are used by governments, and businesses in financial crises as evidenced during the Global Financial Crises.
Reference:
Ross, PB, 1999, Emerging Markets Debt: An Analysis of the Secondary Market, Kluwer Law International, Philadelphia.
Stafford, Johnson, 2010, Debt Management: Backup Options, Macmillan Publishers, London.
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