Financial derivatives have been put under trial, as commentators and public opinion increasingly accuse reckless financial innovation of having inflicted large losses among private and public investors. Structured derivatives are being fingerpointed in particular. But what motivated the proliferation of exotic structures in the first place?

  A crucial motivation was the desire to offer customers new, personalized financial products, indexed with respect to given market variables. Pricing in given market contexts was another factor, as in the rapid diffusion of the Interest Rate Swap (IRS), one of the most widespread type of financial contracts today. It its simplest version, dubbed “plain vanilla”, the IRS foresees the exchange of a sum of money calculated as the difference between a fixed rate (defined at the start of the contract) and a variable rate (periodically measured) on certain notional capital and for a given period of time. The economic function of IRSs is to enable firms which have borrowed at variable rates to protect themselves from the risk of rising interest rates, thereby turning their variable-rate loan into one at a fixed rate, which is indicated by the swap.

  Many of these contracts were offered to the clientele in the 2001-2002 period, when low interest rates in Europe made investors expect their increase likely in the near future. The calculation of the IRS fixed rate (i.e. its pricing) is based on forward rates implicit in yield curves, and on the principle according to which, at the time of signing, actual values of flows in the variable and fixed parts of a swap must coincide. The application of such a principle in a context of rising interest rates can determine an interest rate which is higher than the market rate. This means that somebody investing in a plain vanilla IRS should expect negative cash flows in the first years of the swap contract.

  Such initial negative flows will be compensated by positive cash flows in the longer term. But if forward rates overestimate ex post actual rates, it can be convenient to seek exotic instruments that reduce the fixed rate built into the swap. An example is provided by so-called reduced coupon swaps, where the client pays a fixed interest rate which is lower than a plain vanilla IRS, provided that the interest rate does not go above a certain threshold. Once that threshold is breached, the IRS loses its protective function and the loan goes back to the variable rate.

  Ex ante, such instrument is no worse or no better than a plain vanilla. This is because pricing works in the same way: variable and fixed flows must coincide at the moment the swap comes into existence, but flow distribution changes. The lower the exotic swap’s fixed rate with respect to a plain vanilla, the closer the threshold will be to current levels of interest rates, thus increasing the possibility that the cover provided by the swap is ineffective.

  Summing up, financial derivatives play an important function in managing risk. And in my opinion financial innovation has produced value in recent years, however you want to look at the issue. But when an investor chooses a derivative, he/she must understand very well its features and consequences for cash flows. In particular, clients making use of derivatives must have a clear idea of the risks they incur in by opting for non-vanilla instruments. On the other hand, banks should guarantee the transparence, adequateness and fairness of financial operations, so that trust in the value and importance of financial innovation does not waver.