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Chapter 10*

Derivatives – The Ultimate Financial Innovation
Viral Acharya, Menachem Brenner, Robert Engle, Anthony Lynch and Matthew Richardson

I. General Background and Cost-Benefit Analysis of Derivatives Derivatives are financial contracts whose value is derived from some underlying asset. These assets can include equities and equity indices, bonds, loans, interest rates, exchange rates, commodities, residential and commercial mortgages, and even catastrophes like earthquakes and hurricanes. The contracts come in many forms, but the more common ones include options, forwards/futures and swaps. It is not an exaggeration to state that a considerable portion of financial innovation over the last 30 years has come from the emergence of derivative markets. EXCHANGE TRADED derivatives are dominated by equity derivatives and commodity derivatives. OTC derivatives are mainly in fixed income and currencies. Interest rate derivatives have a notional outstanding of $500 trillion while currency derivatives have a notional outstanding of $60 trillion. Total CDS notional outstanding is $50 trillion. The benefits of derivatives are threefold: (i) risk management, (ii) price discovery, and (iii) enhancement of liquidity. We briefly describe each of these in turn. 1. Benefits

This risk management (hedging) benefit of derivatives to a wide spectrum of economic agents has been recognized centuries ago. Two well-known examples are the Dojima rice futures market in 18th century Japan and the establishment of the CBOT in 1848 to trade forwards on agriculture commodities. Of course, the primary use of derivatives is to hedge one’s positions i.e., to reduce or eliminate the risk inherent in commodities, foreign currencies and financial assets. Farmers who want to guarantee the prices of their future crop can sell them at any time in the futures or forward market. Exporters, exposed to foreign exchange risk, can reduce their risk using derivatives (forward, futures, and options). Pension funds who invest in securities can avoid disastrous consequences by buying insurance in the form of put options. The risk management benefits of derivatives are not limited to hedging one’s exposure to risk but to a whole spectrum of risk-return combinations which can be achieved using options. For example, these features allow one to protect themselves in extremely volatile times like we are witnessing now.

*From Restoring Financial Stability: How to Repair a Failed System, edited by Viral Acharia and Matt Richardson , Wiley , 2009.


Another important benefit is the information that can be extracted from various derivatives. Price discovery is one aspect of it. Some examples include the ABX indices (i.e., portfolio of collateralized debt obligations (CDOs) of subprime mortgages) which were one of the first instruments to provide information to the marketplace on the deteriorating “subprime” securitization market1; exchange traded funds (i.e., ETFs) which provide information on the prices of securities ahead of the stale indexes (e.g., SPY vs. SPX); and option prices on individual equities which reveal private information more quickly into the market2. Derivatives also allow market participants to extract forward looking, as opposed to historical, information. For example, it is commonplace now to back out volatility, skewness (e.g., crash risk) and kurtosis (e.g., fat tails) of an underlying asset from option prices on that asset. Such information is used, among others, by central banks in making policy decisions, investors for risk and return decisions on their portfolios and corporations for managing financial risk. Another example is the expected Fed rate decision obtained from Fed Funds Futures. An additional positive advantage is the enhancement of liquidity. Adding derivatives to an underlying market has two effects; (i) it brings to the market additional players who use the derivatives as a leveraged substitute to trading the...
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