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A Study of Underlying Asset Volatilities and Derivatives Innovation: The Case of China

Author: WeiLuPeng
Tutor: MenMing
School: University of Foreign Trade and Economic
Course: International Trade
Keywords: Underlying Asset of Finance Volatilities Financial derivatives Innovation Supervision
CLC: F224
Type: PhD thesis
Year: 2007
Downloads: 1556
Quote: 6
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Abstract


Campbell, Lo and Mac Kinlay (1997) consider finance as the core of modern economy. It is important for China to develop financial derivatives, which can promote capital market and deepening the reform in financial market. Currently China is reformatting the banking system. It is a good opportunity to develop financial derivatives in China. However, the key issue is how to choose the path of developing financial derivatives in China? There are still some disputes both in academic and professional fields.First, the paper reviews the history and theories of financial derivatives. In theories, financial derivatives derive from and depend on underlying financial asset. The development of financial derivatives depends on the volatilities of underlying asset price. Volatilities of underlying asset are market driving force of developing financial derivatives. In history of financial innovation, innovation of risks management instrument has been characterizing the world financial market since the breakdown of the Bretton Woods. Trading activities of derivatives is based on volatilities of interest rate, exchange rate and stock prices. As the volatilities increase, derivatives develop rapidly. At present, exchange of derivatives in the world mostly aims at interest rate risks. In financial derivatives market, the demand increases and scale extends with greater volatilities of underlying asset. Financial derivatives are used by investors either to manage financial risks or to arbitrage when some financial assets are mispriced. In addition, financial derivatives have also been widely used to enhance competency by multinational corporations. In the history of American derivatives market, the development of financial derivatives depends on volatilities of interest rate, exchange rate and commodity prices. Therefore, this paper starts with volatilities, points out the path of financial derivatives innovation by calculating and analyzing the volatilities of underlying assetThis paper analyses exchange rates of USD/RMB, EUR/RMB and JPY/RMB, interest rates of RMB one-year deposit and loan, stock indexes of Shanghai and Shenzhen, wheat, soybean and copper. By calculating and analyzing the average historical volatilities of underlying asset, I find that the maximum volatility is that of stock index. The minimum volatility is that of USD/ RMB and the volatilities of wheat and soybean dropped in recent year, whereas the volatilities of USD/ RMB exchange rate and copper price tend to increase. Meanwhile, interest rate also exhibits moderate volatility. Using GARCH(1,1) model, this paper studies volatilities and finds that GARCH(1,1) model is not suitable for interest rates of RMB deposit and loan. Estimate results of all others are agree with average historical volatilities.According to the analysis of volatilities, this paper suggests that the innovative route of financial derivatives is developing derivatives of stock, such as stock index futures, at first. Metals options should be developed afterwards. Then we can try to launch grain option. In the next step, Isuggest to develop RMB swaps against foreign currencies. When the conditions were mature, we should expand the business of futures to foreign currencies such as USD, JPY and EUR. Futures of Treasury note can be considered as tools of management interest rate risks exposure. Then we may bring swaps of interest rate into the market if the market-based interest rate is well established.It is important to estimate volatilities forecast model of underlying financial asset. A series of ARCH model is considered in this paper, such as ARCH (1), ARCH (2), GARCH (1,1), GARCH-M, TGARCH and EGARCH model. This paper tries to find out the suitable model of Chinese underlying asset. This paper studies the volatilities of underlying asset such as interest rate, exchange rate, stock index and commodity prices. The findings are that USD/RMB exchange rate and wheat suit ARCH(2) model, JPY/RMB exchange rate and Shibor interest rate suit EGARCH model, EUR/RMB and copper suit GARCH(1,1) model, stock index of Shanghai and Shenzhen suit TGARCH and GARCH-M model respectively.Although there are many overseas papers in Stochastic Volatility (SV) model, there is little paper using SV model in China. Empirical study states SV model is more exact for financial time serial than GARCH model. Estimate methods of SV model mostly are Quasi-Maximum Likelihood (QML), Generalized Method of Moments (GMM), Efficient Method of Moments (EMM) and Markov Chain Monte Carlo (MCMC) method. MCMC method is considered as the best and the most accurate parameter estimate method. Using WinBugs1.4 software, this paper estimates SV model of RMB interest rate, exchange rate, stock index and commodity by MCMC method. Empirical study shows that the volatilities of stock index of Shanghai and Shenzhen persist longer and JPY/RMB and EUR/RMB exchange rate, copper, stock index of Shanghai and Shenzhen suit SV model.Furthermore, this paper studies the supervision issue of derivatives in China. After analyzing types of risks and risks measurement of financial derivatives, I find that there are more risks in financial derivatives market. More effective regulation and supervision are needed for financial derivatives market in China. Financial derivatives markets in U.S. and U.K. have developed earlier and have more perfect mode. In U.S. and U.K., many trading systems for financial derivatives market can be used for our reference, such as market maker, Cleaning house, trading orders and Wild Card Play. This paper Compares Chinese regulatory system and trading system with that in U.S. and U.K.. Finally, the paper suggests: (1) the government should take "moderate supervision" as supervising principle to promulgate the laws for supervise of derivatives in China and define the responsibility of supervising institution; (2) The mechanism of risks valuation should be established in Chinese financial derivatives market; (3) The independent cleaning house, more trading orders and market maker mechanism may be brought into in Chinese financial derivatives market for innovation.

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CLC: > Economic > Economic planning and management > Economic calculation, economic and mathematical methods > Economic and mathematical methods
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