ISE REVIEW

The Impact of Financial Innovation and Risk Management on Economic Performance
Vedat Akgiray

Abstract
The last 25 years have witnessed extensive financial innovation and this had led to revolutionary changes in the international financial system. It is true that financial innovation has been going on since the 17th century and most of the products developed during the last two decades, although mentioned as new, are only versions of much older products. When the history of financial innovation is studied, it is seen that the seemingly new instruments, such as options and futures are not entirely new. For example, organised futures exchanges were established in Chicago, Frankfurts and London in the 19th century. Options and futures-like contracts in Amsterdam and forward contracts in rice in Japan were traded in the 17th century. However, the proliferation of organised markets in derivatives securities around the world during the last two decades is unparalleled in history. Miller (1992) describes the 1970-1990 period as unique in history, in that “no 20-year in financial history has witnessed an even remotely comparable burst of innovative activity.” The development of such standardised markets has subsequently led to the design and implementation of a wide range of new financial products, some for everyone to use and some custom-made to meet specific needs of investors and corporations. To take a very small example out of the range of products developed in this period, it is sufficient only to mention financial futures, options and option-like products, swaps, exchangeable bonds, junk bonds, asset-based securitized investments and hybrids of these and others.

Abstract
The concern over how trading in futures contracts affects the spot market for underlying assets has been an interesting subject for investors, market makers, academicians and regulators alike. With the introduction of futures contracts in financial markets, the desirability of such derivative instruments for the efficient functioning of those markets were questioned. Existence of futures contracts in any market is expected to provide the investors in spot (cash) markets with means of hedging risk. In addition, the futures markets should be the vehicle for price discovery in the spot market for underlying assets. Yet over years, especially with the experience in financial derivative instruments, there seems to be some concern for the undesirable impact of these markets on spot markets. The critics argue that introduction of futures contracts in financial markets has increased the volatility in spot markets and attracted more speculators than hedgers so as to destabilise cash markets in some instances. The impact on liquidity, according to the critics, may not be favourable either. The stock market crash of October 1987 strengthened the criticisms, as the rapid and persistent decline in prices in a very short time period were at least partially blamed on program trading strategies such as portfolio insurance and index arbitrage. These strategies are well known for their dependence on derivative instruments like stock index futures and options. The objective of this note is to review the literature on the impact of stock index futures on stock markets. Specifically, the evidence for change in overall volatility and liquidity after the introduction of stock index futures is reviewed. In addition, theoretical pricing of index futures and arbitrage opportunities, as well as the lead-lag relationship between spot and futures markets are addressed.

When to Start Financial Derivatives Trading? The Example of Istanbul Stock Exchange
Oral Erdogan & Murad Kayacan

Abstract
A fundamental step in the development of financial markets is the introduction of derivative products, which are structured to facilitate hedging. By integrating the expectations on the future prices of securities into the market transactions, the resultant liquidity increases the trust-worthiness of the exchange for the individual traders. Emerging rapidly since the 1970’s, the subject of derivatives market has been attracting much debate both in the markets that currently host derivatives trading and financial centers that are on the verge of launching such market segments. In this paper, the choice of financial instruments and the timing for the initiation of derivatives trading in the securities markets are briefly assessed and the compatibility of a derivatives market to the ISE’s spot market is evaluated in terms of volatility, the representative aspect of the systematic risk as well as the market depth within Ederington’s (1979) portfolio approach. In conclusion, futures and/or options, based on the stock indices, are deemed as necessary for hedging purposes in the capital markets. However, since the basic risk factor is a result of interest volatility, it should be adequately discussed if there should be a priority for derivative instruments based on interest rates.

Abstract
Turkish Capital Markets have shown a considerable growth in the last decade both in terms of quality and quantity and have become more internationalized by offering new markets and financial instruments to the investors. Istanbul Stock Exchange (ISE), being the only securities exchange of Turkey, will now launch a new market, namely the “Derivatives Market”, and introduce new financial products to both domestic and foreign investors in order to provide new opportunities for hedging the risks born on the Turkish financial markets. This article aims to explain the trading system as well as the clearing system of the ISE Derivatives Market.

Launching Markets for Stock Index Futures and Options: Case of Korea
Yu-Kyung Kim

Abstract
This paper discusses experiences on launching Korea’s first-ever regulated derivatives market, namely stock index futures, on May 3, 1996, and subsequent opening of a stock index options market on July 7, 1997. It illustrates what went on as the Korea Stock Exchange was making a decision on its opening and describes the current status of the derivatives market.

The Right Time to Introduce a Derivatives Market
Moema Unis

Abstract
In recent years, we have witnessed a profound change taking place in the capital markets worldwide. This process began in the early 1970s when exchange rates were left to float and capital markets entered a new phase. The world became more unpredictable and the economic agents learned the importance of a factor to which little attention had thus far been paid: the risk associated with price and market instability. The existence of risk led to a demand for hedge instruments. This was the birth of the so-called financial derivatives two decades ago. Today, some countries are using derivatives to hedge themselves against price and market risks, and some others are about to initiate derivatives trading in their securities market. This paper argues the right timing of launching derivatives market with the light of Brazilian experience.

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