Historically, when a nation’s current account deficit surpasses 5% of GDP a correction occurs in
currency value. Before the financial crisis the U.S. was able to consistently run current account
deficits above 5% because foreigners were willing to supply funds to U.S. markets. Part of the
reason for this is the usage of the U.S. dollar as a global reserve currency. Currency
manipulation by foreign central banks also contributed to the strength of the dollar. For instance,
foreign central banks continue to purchase dollars to keep local currencies down to foster their
export sectors. The U.S. economy and the dollar remain key generators of global growth and
these factors help the dollar maintain its value in the global market. The recent strength in the
dollar has reduced profitability of some well-known U.S. multinationals with significant
overseas revenues such as IBM. Nevertheless, over the longer term the dollar continues on a
declining trend. The dollar’s drop can generate long term inflation concerns and lead to higher
commodity prices because most commodities are priced in dollars regardless of where they are
traded globally.
d. Derivative Security Markets
A derivative security is a contract which derives its value from some underlying asset or market
condition. In general, the main purpose of the derivatives markets is to transfer risk between
market participants. Some participants, called hedgers, enter derivatives contracts to reduce
their risk exposure in the underlying cash market. Other participants, called speculators, use
derivative contracts to bet on price movements. Derivatives are highly leveraged instruments.
Leverage allows hedgers to reduce risk and speculators to attempt to earn high rates of return
with low capital investments. The two main types of derivatives markets are the market for
exchange traded derivatives and the over the counter (OTC) derivatives markets. Exchange
traded derivatives are generally liquid and involve no counterparty risk, whereas OTC contracts
are custom contracts negotiated between two counterparties and have default risk.
Derivatives have been blamed for the financial crisis. Mortgage derivatives did allow a larger
amount of mortgage credit to be created, and spread the risk of mortgages to a broader base of
investors. Subprime mortgage losses were large, reaching over $700 billion. The instructor may
wish to ask students whether it makes sense to blame the instrument or the users. Warren Buffett
has called derivatives, ‘weapons of mass destruction.’ However, used properly they allow
market participants to transfer risk to other parties and allow others lower cost methods to gain
exposure to markets. It does seem reasonable to require greater transparency in OTC derivatives
to ensure that players can cover the promises they make. Derivatives that involve payments of
principal, such as credit default swaps, are now supposed to be traded on an exchange to ensure
performance and reasonable limits to speculation.
e. Financial Market Regulation
Financial markets are regulated by the SEC, the exchanges, the Commodity Futures Trading
Commission (CFTC) and the Financial Industry Regulatory Body (FINRA) (FINRA resulted
from a merger of the NASD and the NYSE regulatory arm in 1996 and supersedes both).
FINFRA is a self-regulatory body that is subject to SEC oversight. The primary purposes of
regulations are to prevent fraud, to ensure performance as promised, and to ensure that the public
has enough information to evaluate the riskiness of an investment. The regulators do not attempt
to ensure investors earn a minimum rate of return.