A Quantitative and Qualitative Inquiry into the Factors That Motivate Banks to Use Financial Derivative

P.h.D Research Proposal
Doctoral Program in Governance
A Quantitative and Qualitative Inquiry into the Factors That Motivate
Banks to Use Financial Derivative
Patrick Kibui
Email: ******************
Word Count: 4510
Submitted on 22/02/2016
Key Words: The use of derivatives, Regulation, History of Derivatives, Mixed methods

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Table of content Page No
Abstract iii
1.0 Introduction 1
1.2 Problem topics 2
1.3 Problem Statements 2
2.0 Literature Review 3
2.1 Types of Financial Derivatives 3
2.1.1 A Brief History of Commodity Market 3
2.1.2 Forward Contracts 6
2.1.3 Future contracts 6
2.1.4 Options 6
2.1.5 Swaps 6
2.2 Derivatives and their uses 7
2.3 Regulation of Reforms 8
3.0 Research Design 11
3.1 Research process 11
3.2 Population and Sampling 12
3.3 Data collection techniques and analysis procedures 12
3.4 Gaining access 13
4.0 Outcomes and Significance 14
References 15

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Abstract
The financial derivative play a unique role in the economy and has undergone transformations
since the writing of philosophers Thales of Miletus in ancient Greece. The motivate for banks to
use derivative instruments are risk management, hedging, speculation, price discovery, to
reduce cost of debt, liability diversification and as an income generating segment. Derivative
instruments have been accused as the main cause of financial crisis and being viewed as a
weapon of mass destruction. The fear of another crisis as forced market regulators to come up
with reforms aimed at improving transparency, mitigate systematic risk and safeguard against
market abuse. The purpose of this study was to explore factors that motivate banks to use
derivatives and the nature of reforms proposed that relates to OTC derivatives. The nature of a
derivative, its origin, and the rationale for being used will be addressed. This research will adopt
a mixed method design, both quantitative and qualitative techniques will be used. Quantitative
method will be the main tool for the research, and will be integrated with qualitative during the
interpretation phase, which is more about sequential explanatory design. The derivatives play a
significant role in the economy by transferring risk from one party to another. Even though
derivatives are risky when handle with care they can bring substantial economic benefit. The
characteristics of derivative instruments explored in this analysis provides a suggestions for
further research on the correlation between derivative instruments and financial crisis since
inception.

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1.0 Introduction
In a world of innovations, one naturally assumes that institutions engage in the management of
risk and protecting against adverse movement of currencies, commodity prices, and interest
rates. For the success of this institution, they have to use financial derivative as the best method
to manage these risks (Till, 2014).These derivatives instruments are associated with a specific
financial tool, i.e. commodity, with precise financial risks traded in financial markets in their own
right. Derivatives are used in various ways, such as risk management, arbitrage between
markets, speculation, and hedging (Chance and Brooks, 2015).
Recently, the OTC has been accused as the major cause of the latest financial crisis because of
weaknesses in the infrastructure of the derivatives markets (Almunajem, 2015).The history tells
us that OTC derivatives has destabilized the economy since time in memorial. These might
include the tulip mania of 1637, the Latin American debt crisis of 1825, the Wall Street crashes
of 1929, the Asian crises of 1997 (Neal and Weidenmier, 2003), the financial crisis of 2008, and
now the European sovereign debt crisis (Beirne and Fratzscher, 2013). This might be the
reason why derivatives are viewed as “time bombs and weapon of mass destruction” by Warren
Buffet (Boyd, 2015). However, when managed well will lead to higher economic growth,
earnings opportunities, improve credit risk management, financial innovation, market
development and increase market resilience to shock (Chance and Brooks, 2015).
Furthermore, derivatives play a significant role in the financial system; hence have a positive
impact on the economy, although they are associated with certain risks (Riederová, 2011).
These risks are not adequately mitigated and the European Commission has been working to
address them. Derivatives markets are sensitive and regulators intended to improve
competition, transparency, resilience of the market segment and reduce systematic risk.
However, with the introduction of these reforms, it is believed to undermine derivative markets
and a threat to Europe’s economic growth (Stafford, 2015).

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1.2 Problem topics
In the wake of new financial products and the events of the 2008 financial crisis, regulation of
derivatives has become an issue. The purpose of this sequence, mixed methods study is to
explore and develop themes about the use of derivative instruments in banking sector taking
into account the US and the EU financial system which are more sophisticated and are the two
largest derivatives market. The following research question will be used.
• How do the derivatives regulation changed the derivatives environment in EU and USA
and their reasons for being extensively used by the banks? While critically analyzing
their history of origin, factors that motivate banks to use them, the relationship with the
financial crisis and the effects of reforms on derivative market.
1.3 Problem Statements
Buffett said that derivative “at some point they are likely to cause big trouble" and they are a
threat to financial market because they are prone to speculation (Boyd, 2015). Derivative market
has undergone various transformations since its inception in17th-century, such as rice in Japan
and tulip bulbs in Holland (Stulz, 2005). In 1970s, markets were small, but due to economic
growth, it led to an increase in interest rate volatility thus making it crucial to hedge. In addition,
the growth of internal trade and flow of capital has increased the demand of financial derivatives
to mitigate the risk (Mishkin, 2006).
Various incidents occurred during the 1970s that were the catalyst of modern derivatives. For
example, the collapse of the fixed exchange rate regime might have been the source for the
trading of foreign-exchange derivatives, and the discovery of Black and Scholes model allowed
traders to buy or sell an asset. This was as a result of rapid innovation in the world of
computing, which allowed fast processing of complex data to be resolved and moderate
regulation mechanism (Kummer and Pauletto, 2012).

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The emergence of OTC has provided the users, who are mitigating the risks, the ability to enter
into a tailor-made contract that matches their unique risk profile. User can buy and sell contracts
that either doesn't exist or don’t have sufficient cash flow for exchange (Poitras, 2009). This
means that there is a risk of transferability and an exchange mechanism is required to settle the
arrangement. In addition, OTC derivative were decentralized and unregulated and the user
could hedge without posting daily margin since it was not mandatory (Moore and Khoja, 2008).
The consequence of unregulated OTC derivatives market was the main cause of the crisis
because they related directly with large financial institutions that were seen as “too big to
fail”(Zhou, 2009). However, with the establishment of regulators’ and fear of another financial
crisis, clearing houses are collecting collateral at the beginning of each contract, observe daily
price movements and merchants pay for losses when they occur (Roe, 2011; Oakley, 2015).
2.0 Literature Review
The history of the evolution of derivative instrument is amazing how old it is. Few authors have
written about it and their regulation, even though it is incomplete at best. In this section, a brief
history of the derivative will be discussed.
2.1 Types of Financial Derivatives
The derivative is defined as those assets whose value are determined by the value of some
other assets, called the underlying (Peery, 2012). This section will highlight the major
classification of the derivative instrument.
2.1.1 A Brief History of Commodity Market
The history of derivatives can be traced in the Bible. In Genesis Chapter 29, the story of Jacob
took place around 1700 BC. Rachel was sold to Jacob for an option of seven years of service
for the right to marry. Laban defaulted this derivative and offered Leah to Jacob, who was not
part of the contract. Jacob was asked to purchase another option to marry Rachel. This might
be compared to a forward contract with an obligation to the marriage (Chance, 2011).

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A call option on olives can be traced to the writing of philosophers Thales of Miletus in ancient
Greece at around 580 BC, when farmers negotiated for the contract before harvest (Chatnani,
2010). Furthermore, Swan (2000) said that these derivative agreements were being used by
olive farmers to reduce the price risk associated with future harvest. On the same note, farmers
were given three kuru of barley by the King’s daughter to be returned after the harvest. This
contract might be compared to a commodity loan borrowed by the farmers with the hope that
they will be returned after harvest. It shows that the farmers took some risk; if the crops failed,
they were still required to return the barley to the King’s daughter.
Rice contract was traded in both China and Japan, in China farmers entered into an agreement
to sell rice at a future date for stated price. These contracts were negotiated before planting
season. In addition, speculators were eliminated as grain was secured from the farmers during
the reign of Imperial China (Hou, 1997). Swan (2000) said that during the 17th century, Japan
traded on future rice by issuing tickets as a promise of delivery. The ticket was an obligation to
deliver rice in the future date at a particular price and quantity. Since the future price was fixed
at the present date, the traders were able to reduce the risk of adverse movement in price.
In the 1550s, buying and selling of tulips were conducted by craftsmen and merchant. As the
demand of tulips increased significantly, the merchants were forced to enter into a future
contract to mitigate the effect of high prices. In 1937, tulip market crashed, investors were left
bankrupt. Charles Mackay said the reason why price changed was as a result of financial
market irrationality. However, Peter Garber blamed the public for high prices and the risk
involved. The Dutch government associated tulip contracts with gambling hence were
unenforceable. In addition to this, Mr. Garber said that speculation was one of the causes of
extremely high prices of tulips (Garber, 1989).
The Royal Exchange was formed in 1571 as the first world commodity market. It faced various
challenges such as how to deal with speculators who were trading at the Alley and who ignored
derivative legislations trading on future options (Peery, 2012). It lead to enactment of Gaming

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act and Bernard Act to enforce forward and future contract, and introduce punitive measures on
speculation, even though it was unsuccessful in eradicating this menace. With those
shortcomings, the legal defense was removed, making the broker accountable and to close the
deal in case the customer default. This eliminated speculative plague that had infected OTC
trading of option contracts then.
“Time-contracts” was available is Germany at the beginning of the 19th century and were
classified into forward and options contracts and related to future delivery (Weber, 2008).
Furthermore, Germany exchange served as a marketplace for trading bonds, bills of exchange
and foreign currencies. Six-month futures contract was available in Germany mark notes, even
though speculators settled their differences every month. However, at the end of the19th
century, banks collapse as a result of futures speculation on the exchange. Trading on future
commodities on grain was banned due to price manipulation, abuse of transaction by traders
and short seller (Peery, 2012).
The modern day derivative was established in 1848 when the Chicago Board of Trade (CBOT)
created the first formal commodities exchange. This might have led to the creation of a place
where merchants negotiated forward contracts and found a solution to mitigate credit risk
(Pathak, 2011). CBOT faced numerous challenges such as facilities were over-utilize and
under-utilized during the low season, volatility of grain prices and sometimes parties to the deal
walked away hence increasing counterparty risks (Kummer and Pauletto, 2012). The volatility of
price might have led to the creation of “to-arrive” contracts, which allowed farmers to lock in the
price and deliver the grain a few months later. “To-arrive” contracts were used as an instrument
for hedging as well as for speculating on price changes (Madhumathi and Ranganatham, 2012).
On flip side contract “to-arrive’’ price was distorted, speculation, fraud, and manipulation were
rampant (Greenberger, 2010).

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2.1.2 Forward Contracts
A forward contract is a tailor-made contract involving two parties to buy or sell an asset at a
future date for a certain price (Jarrow and Oldfield, 1981). A forward contract is not traded on an
exchange, but traded over the counter, between two financial institutions or one of its clients.
Forward contracts are a two-sided wager and are open to counterparty risk. These risks are
non-performance of obligation by either of the parties to the contract (Gupta, 2005).
2.1.3 Future contracts
Similar to a forward contract, a future contract involves two parties to buy or sell an asset at a
specified price and at a specified time and place (Gupta, 2005). Future contracts are
standardized and are traded on an exchange, called futures exchange. For every future
exchange, there are specific settlement dates for a future contract. These dates are in March,
June, September, and December. This shows that the future contracts specify the delivery
month rather than the day and during the month.
2.1.4 Options
An option is a contract that gives the buyer of the option a choice whether to enforce the terms
of the contract agreement or to let the contract lapse. An option gives its owner the right but
does not impose the obligation, either to buy or to sell a quantity of a particular item at a set
price on, or up to, a given future date (MacKenzie, 2005).
2.1.5 Swaps
A swap is an agreement by which two entities will agree to exchange cash flows in the future or
before a specified future date based on the underlying asset. Unlike futures, swaps are not
exchange-traded instruments. Swaps can also be used to hedge against an adverse movement
in interest rates and are usually designed by banks and financial institutions that also arrange
the trading of these bilateral contracts (Mahajan and Singh, 2015).

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2.2 Derivatives and their uses
Banks are motivated to use derivatives for hedging against the risk, revenue and fee collection
that relate to derivatives trading (Li and Marinč, 2013). To hedge, banks require financial
software and capital investment which is at their disposal. Paligorova and Staskow (2014) said
that the profit motive and low volatility are the reason for hedging which has enhanced the ability
to raise capital, reduce revenue volatility and investment decisions. This assumption was
supported by Campello et al. (2011) when they said that it lower the cost of debt with less
investment restriction. While Géczy et al. (1997) said it will reduce cash flow fluctuations and
enhance investors’ confidence due to lower gearing and increase company value.
Chance and Brooks (2015) identified derivatives tools as a means of managing risk, discovering
price, reducing costs, improving liquidity, short selling, and making the market more efficient.
Although Gatev and Strahan (2006) said that banks facilitate those investors seeking to reduce
their risk and to transfer it to those wanting to increase. Whilst in the future and forward market,
banks collect information showing the spot price of the underlying asset on which the future
price is based hence being used to provide price discovery (Hull et al., 2013). Besides that,
derivatives entail lower transaction cost, which means that companies and other trading cost are
lower for traders in these markets (Flannery, 1996).
Guay (1999) said that derivatives are primarily used by firms for hedging purposes, that is, to
reduce the financial risk. International firms are prone to foreign exchange risk than local firms,
hedging is of great relief to them. International firms use derivatives to minimize the interest rate
risk and currency risk exposure. Hedging is seen as a ways to increase companies’ value. Even
though, Grant and Marshall (1997) argued that derivatives are hardly being used to speculate
on market movement; but are being used to reduce the volatility of institutions cash flows. This
might mean that swaps, forwards and options are mostly used to manage foreign exchange and
interest rate risks.

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Furthermore, Vashishtha and Kumar (2010) acknowledged that derivatives are instruments to
manage risk, speculation, price discovery and efficiency in trading. This might mean that swaps,
forwards and options are mostly used to manage foreign exchange and interest rate risks.
Banks that use interest rate derivatives tend to increase the income generating segment by
lending faster than banks that do not use interest rate derivatives (Brewer et al., 2000). This
bank would use derivatives to hedge against the uncontrollable risks, thus saving them time to
concentrate on their core competence and operational efficiency (Osuoha, 2009).
Since banks act as financial intermediaries they are prone to interest rate risk when they create
a mismatch in the pricing of asset and liability. They use financial tools such as interest rate
derivatives to manage these risks. Diamond (1984) said that banks need to hedge systematic
risk in case they lack an internal mechanism to monitor the interest volatility. Interest rate
fluctuation has caused financial distress and bank failure in recent years, and to avoid these
calamities they need to hedge against them (Purnanandam, 2007). Besides that, the external
shocks on bank’s operating policies might be minimized by the use of derivatives
(Purnanandam, 2004)
Shiu et al. (2010) said the size of the bank, the degree of currency exposure and liability
diversification are motives of banks to use derivatives. The call for off-balance sheet hedging is
as a result of information being available and currency exposure. This might clarify the
alternative outcomes for interest rate and currency rate related activity, hence might explain why
derivative instruments act as a motivation tool in the management of risk. Although limited
evidence for risk reduction is available and has no bearing on bank’s risk, market risk and
unsystematic risk as pioneered by Hentschel and Kothari (2001).
2.3 Regulation of Reforms
In the wake of the financial crisis, the Leaders of the G20 nations agreed to a series of
measures to improve transparency, reduce systemic risk and protect against market abuse.

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Others have criticized the alleged opaqueness and impenetrable of OTC derivative instruments
as being time boom due to their volatility and nature of systemic risks (Kono, 2013).
The banking sector reflects regulatory arbitrage and the ability to innovate and go round the
regulatory machinery intended to contain it taking the risk. Leaving this regulatory unchecked for
several years was a failure by everybody to comprehend the consequences of regulation, the
ideology of the time and the development of tools to deal with them (Acharyaet al, 2010). Banks
have received attention due to the crisis they have caused, the risk involved and being accused
of employing “vertical silos”, where clearing house only processes contract owned and traded
with them (European Commission, 2015). This has lead to lack of competition due to barriers to
entry as they control these houses.
The current outlook is that many countries are in the process of implementing these new
changes on derivative-related activities (IOSCO, 2015). These reforms will bring changes to the
financial markets as proposed by Dodd-Frank Wall Street Reforms and other regulatory in
different ways (Morrison and Foerster, 2010).These derivatives reforms are:
1. Lincoln Provision (the “Swaps Pushout” Rule): aimed at promoting accountability and
transparency in financial markets and prohibit the government from “bailing out,”
institution losses that arose from risky financial transaction such as swaps. However, this
rule has been amended to allow institutions to engage in CDIs activity, hence exposing
taxpayers to more financial risk (Lay, 2015).
2. Regulatory Framework and Key Definitions: aimed at the establishment of the regulatory
framework and division of duties and responsibility for the CFTC and SEC.
3. Clearing and Trading Requirements: requires that all market participants must have
access to central clearing house and standardized OTC derivative must be cleared
through CCPs (Deloitte, 2014).

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4. Regulation of Swap Dealers and Major Swap Participants: Swap dealers and major
swap participants must register as such and will be subject to a regulatory
regime(Morrison and Foerster, 2010).
This reform will bring a comprehensive and far-reaching regulatory regime on derivatives and
market participants (Morrison and Foerster, 2010).However, in the process of implementing
them, derivative players are complaining because of conflicting regulations such as to separate
US and EU clearing house (Chaffee, 2011). In addition, lack of trust by regulators to believe that
regulation in other countries are adequate and will deliver a similar level of protection to its own
(Deutsche Bank Research, 2011).
Besides that, Deloitte (2013) said that EU derivatives reforms will lead to similar regulatory
result as those in US derivatives. This seems to show that the two regimes will deliver the same
goal and reduce systematic risk, improving transparency, combating market abuse and
supporting financial stability. This is positive news to market participant and regulators at this
point in time as they embark on rule harmonization and implementation. For the rules to be
successful, regulators need to acknowledge the robustness and consistency of other players in
the global environment. Without it, market participants are faced with uncertainty, unduly
complex implementation plans and market fragmentation.
In the wake of these reforms, the war on derivative trading is far from the finish, since they are
risky and banks can’t account for them (Campbell-Verduyn, 2015). According to Braithwaite et
al. (2010), victory over Wall Street are still not over, these rules are toothless when the
custodians of derivative instrument can’t keep track of them as they moan that it is too
expensive to keep up with all the enormous paperwork required. With this regard, there is a
need for Global Leader to come up with standards for the regulation of market participants in
derivatives market when dealing with intermediating transaction.

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3.0 Research Design
This study will adopt a mixed method design, both quantitative and qualitative techniques will be
used Quantitative method will be the main tool for the research, and will be integrated with
qualitative during the interpretation phase, which is more about sequential explanatory design
(Tashakkori and Teddlie, 2003). Thus, when quantitative data leads the qualitative data, the
focus is to test the variables with a large sample and then carry out a more in-depth exploration
of a few cases during the qualitative phase (Azorín and Cameron, 2010).The following sub-
sections will describe the research process and data analysis. The reason for choosing mixed
method are:
• Mixed methodology is more appropriate to investigate the real life banking practice and
is realistic. In addition, is superior since it answers questions that other methods cannot,
it has stronger inferences and it allows divergent findings (Teddlie and Tashakkori,
2009).
• Is more appropriate in answering a particular question than the other and would be
adopting the position of the pragmatist (Saunders et al., 2011).
This study, the objective will be to describe factors that motivate banks to use derivative
instruments and how reforms have affected them. This meant that a single research method will
not be appropriate because of the complexity of the derivatives instruments, the attitude of the
bank towards the risk and the nature of the reforms.
3.1 Research process
This research will consist of two sequential stages. In stage one of the research, a quantitative
survey will be used. It will be conducted at one point in time and can be described as cross-
sectional. The tool to be used will be the questionnaire and will be administered
electronically.This method is the best because it offers standardized questionnaire, even though
they are not good for exploratory research that has many open-ended questions (Robson,

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2002). A pre-survey contact will be done where the respondent is advised to expect the
questionnaire by email.
In phase two, few individual will be interviewed who participated in the survey to have in-depth
information about derivative instruments. This is similar to the sequential explanatory design
where quantitative data are collected first to explore the issue in details, then followed by
qualitative methods which enable to get an in-depth knowledge of the issue through interviews.
Teddlie and Tashakkori (2003) said that for phase two research questions they come from the
inferences of the phase one. The reason for the phase two is to explore the correlation between
the motive for the use of derivative, financial crisis, and how proposed reforms have affected
them, semi-structured interviews will be conducted as a means of exploring the banking sectors
to establish their relationship. Carson et al. (2001) said that the use of in-depth interviews is
aimed at gaining an understanding and meaning while being flexible and an element of
structure.
3.2 Population and Sampling
The study population in this research will be the Germany Banks, who deal with derivative
instruments (Burns and Grove, 2003). The survey will be based on random sampling technique.
The sample size will be controlled when saturation point of information is reached which means
repetition of previously collected data occurs (StreubertSpeziale and Carpenter, 2003).
However, for in-depth interview Guest et al., (2006) said a sample size of 12 interviews is
sufficient when drawn within a fairly homogenous group whilst (Creswell, 2007) said that to be
sufficient a sample size of between 25 and 30 interviews.
3.3 Data collection techniques and analysis procedures
The quantitative data collected will be analyzed using charts, graphs, and statistics. This will
help us to explore, presents, describe and explain the relationship within our data (Saunders et
al., 2011). Data will be presented in the form of a table and diagram that show the frequency of

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occurrence to enable comparison through establishing statistical relationships between
variables.Data will be analyzed using computer software such as SPPS for windows.
In phase one, secondary data will be collected from online database and will be used to
construct and provide a theoretical understanding of a brief history of the derivative. From the
data collected and analyzed, the researcher will try and shed light what motivated users of the
derivative instrument to use them and the correlations with financial crisis during that period.
After gathering secondary data, the researcher will use questionnaires which will be sent to the
Germany banks and analyzed using a grounded theory approach. Data will be reorganized
according to category while looking for dominant theme or relationship (Dey, 1993).
Additional qualitative data based on in-depth interviews with financial managers and financial
analyst will be conducted and analyzed qualitatively to clarify the content of some of the
questionnaire results. This will be important to get at the meaning behind some of the data while
seeking new insights’ (Robson, 2002). Various question format will be used such as open ended
to allow the interviewee to define and describe a situation and probing questions to explore
responses that are of importance to the research topic. Miles and Huberman (1994) said that for
in-depth interviews, an inductive content analysis might be conducted on the interview
transcripts using text mining software to scan and analyses the transcribed documents. This will
condense and keep the data concise which is valuable when presenting data from multiple
methods (Hohenthal, 2006).
3.4 Gaining access
The researcher will use company website to gather information about the company and also
about the head office and their contacts. The company will be conducted by telephone and the
researcher will introduce himself by providing various information such as he is a student, title of
the course, and the name of the university. The researcher will also explain briefly the nature of
the research to be conducted to the person who answers the telephone. This will result in being

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provided with the contacts of the gatekeeper who I will contact. In case the person that I am
dealing with is of little help, I will ask politely to be transferred to the appropriate person.This
process will continue until I get the right person whom I will send an email requesting for a
meeting with him at his convenience (Saunders et al., 2011).
4.0 Outcomes and Significance
In conclusion the derivative instrument has become an important tool in the international market;
it plays a significant role in the economy by transferring risk from one party to another.
Derivatives stand accused as the main contributor of the financial crisis in the world. However, if
handled with great care they can bring substantial economic benefit. These tools help economic
mediator to enhance their risk management skills while fostering innovation culture that is aimed
to develop and increase market resilience to shock. The role of the banks and the tools
available for managing the risks has evolved during the last decade. This has opened the eyes
of regulators as they are faced with the challenge of controlling various exposures facing
financial institutions. Regulators have come up with new regulations that are aimed at
preventing the taking of excessive risk while slowing the financial innovation. This is important
for the banks as exposure has a potential to split over to the economy and cause another crisis.
While writing this proposal, the various challenges were encountered i.e. how to formulate a
descriptive mixed method research question using sequential approach and writing research
methodology. However, it was less demanding while writing literature review. In conclusion, the
link between derivative and the financial crisis need to be explored further as a stand-alone
topic.

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