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IFT Notes for Level I CFA® Program
IFT Notes for Level I CFA® Program

R48 Derivative Markets and Instruments

Part 4


 

5.  The Purposes and Benefits of Derivatives

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.

Information Discovery

There are two primary advantages of futures markets:

  • Price discovery: Futures prices reveal more information than spot prices. For commodities that trade worldwide like gold, a futures contract expiring soon is a better indicator of its value than gold price in India or the U.S. which may be wide apart.
  • Implied volatility: Implied volatility measures the risk of the underlying or the uncertainty associated with options. With the models such as BSM to price an option, it is possible to determine the implied volatility, and hence the risk.

Operational Advantages

Some of the major operational advantages associated with derivatives are given below:

  • Lower transaction costs than the underlying.
  • Greater liquidity than the underlying spot markets.
  • Easy to take a short position.

Margin requirements and option premiums are low relative to the cost of the underlying

Market Efficiency

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.

6.  Criticisms and Misuses of Derivatives

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.

Complexity

Another criticism of derivatives is their complexity. The models are highly complex and are not easily comprehensible by everyone.


Derivative Markets and Instruments Part 4