The modern derivatives market finds its origin with the formation of the Chicago Board of Trade in 1848. In the mid-1800s, Chicago was becoming a major hub of transportation and commerce where farmers gathered to sell their agricultural produce every year from September to November. As the city’s storage capacity was not adequate to store all the grains during this period, some farmers found it economical to dump the grains in the Chicago River (literally!) than cart it all the way back to their farms. The rest of the year, the prices of the grains would rise sharply.
The Chicago Board of Trade introduced a financial instrument called a “to-arrive” contract that a farmer could sell anytime of the year that specified the price and delivery date for the grain. On that pre-determined date, he could deliver the grain. This ensured the farmers got a fair price for their produce all through the year by entering into a contract ahead of time to deliver the grains at some point in the future.
Some of the benefits of derivatives are listed below:
Risk Allocation, Transfer, and Management
Derivatives are a cost-effective way of transferring risk from one party to another. For example, if an investor has a substantial investment in a stock that he does not want to sell but reduce the risk, he can do so by taking a short position in a futures contract or buying a put option.
There are two primary advantages of futures markets:
Some of the major operational advantages associated with derivatives are given below:
Margin requirements and option premiums are low relative to the cost of the underlying
Any mispricing is corrected more quickly in the derivatives market than the spot market because of operational advantages: low transaction costs, easier to take a short position, etc. The market is more liquid as it attracts more market participants because of its low cost to trade.
They allow investors to participate in price movements, both long and short positions are allowed.
Some instruments may not be bought directly, but an investor can gain exposure to these instruments through derivatives. For example, the weather.
Studies researching the cause of a crash over the past 30 years always point to derivatives as one of the primary reasons. The sub-prime crisis of 2007-08 was also caused by a derivative – Credit Default Swap.
Speculation and Gambling
Derivatives are often compared to gambling as it involves a lot of speculation and risk taking. An important distinction between speculation and gambling is that a very few benefit from gambling. But speculation makes the whole financial markets more efficient.
Destabilization and Systemic Risk
Derivatives are often blamed to have destabilizing consequences on the financial markets. This is primarily due to the high amount of leverage taken by speculators. If the position turns against them, then they default. This triggers a ripple effect causing their creditors to default, creditors’ creditors to default, and so on. A default by speculators impacts the whole system. For example, the credit crisis of 2008.
Another criticism of derivatives is their complexity. The models are highly complex and are not easily comprehensible by everyone.