The 17th century witnessed increasing economic activity by both governments and firms, which necessitated secondary trading and better organisation of the working of financial markets (Sánchez, 2010; Owen et al., 2009). Securities trading markets were opened in Amsterdam, which in turn resulted in the sophistication of trading practices and the development of financial innovation, especially in areas of risk management (Sánchez, 2010; Owen et al., 2009). The development of complex and sophisticated financial instruments and products occurred shortly thereafter (Mention &Torkkeli, 2012; Su& Si., 2015). The recognition of the corporation as a legal entity was considered to be an important financial innovation and resulted in significant changes in the financial sectors (Mention &Torkkeli, 2012; Su& Si., 2015). Financial activity increased on account of faster railway and canal activity, which in turn resulted in the development of more complex forms of bonds and equity (Laevenet al., 2015; Schueffel&Vadana, 2015). Increasing need for capital in the USA on account of enhancement in railway construction and the civil war resulted in the development of various forms of financial securities, including warrants, commercial paper and income bonds (Laevenet al., 2015; Schueffel&Vadana, 2015).
Whilst financial instruments experienced relative stability after the depression of the 1930s and the Second World War, the pace of innovation increased swiftly from the 1960s onward on account of various factors, including alterations in underlying finance technologies, namely telecommunications and data processing, changes in regulation, liberalisation, alterations in the economic environment and an increasing desire to circumvent regulation (Owen et al., 2009; Mention &Torkkeli, 2012). Firms gradually introduced instruments like floating rate notes and zero coupon bonds (Wyman, 2012; Laevenet al., 2015). Mention and Torkkeli (2014) stated that currency swaps were developed by British banks in the 1960s to avoid exchange control regulations, whereas securitised loans were developed in the USA in the 1970s. Acceleration in technological advances led to the creation of diverse innovations that were related to processes, like for example credit and debit cards, telephone and online banking systems and automated teller machines (Schueffel&Vadana, 2015; Railiene, 2015). The concept of securitisation, which involved the conversion of illiquid and cumbersome financial contracts into instruments that were liquid, as well as of lesser denomination followed thereafter (Schueffel&Vadana, 2015; Railiene, 2015). The development of such instruments, which could be traded on capital markets, was followed by the development of sophisticated asset backed securities, including collateralised debt obligations (Owen et al., 2009; Mention &Torkkeli, 2012).
It is evident from the preceding information that evolution of financial instruments has occurred in a progressive manner over the course of 5000 years, beginning with the Mesopotamian civilisation in 3000 BCE. These instruments have developed and become increasingly sophisticated over time and have contributed in various ways to the enrichment of the current financial systems.
3.3. Types of Innovative Financial Instruments and Associated Risks
As elaborated in the earlier section, financial instruments have on account of continuous innovation evolved enormously over the years and can be classified into various types. This section of the dissertation engages in a discussion of the various types of innovative financial instruments and their associated risks. Li et al., (2009) stated that financial instruments involved various types o
