The Impact of Derivatives on Cash Market

Topics: Futures contract, Option, Derivatives Pages: 62 (21528 words) Published: August 18, 2010
The Impact of Derivatives on Cash Markets: What Have We Learned? Stewart Mayhew Department of Banking and Finance Terry College of Business University of Georgia Athens, GA 30602-6253 October 27, 1999 Revised: February 3, 2000

The Impact of Derivatives on Cash Markets: What Have We Learned?

Abstract This paper summarizes the theoretical and empirical research on how the introduction of derivative securities affects the underlying market. A wide array of theoretical approaches has been applied to the question of how speculative trading, the introduction of futures, or the introduction of options might affect the stability, liquidity and price informativeness of asset markets. In most cases, the resulting models predict that speculative trading and derivative markets stabilize the underlying market under certain restrictive conditions, but in general the predictions can go either way, depending on parameter values. The empirical evidence suggests that the introduction of derivatives does not destabilize the underlying market—either there is no effect or there is a decline in volatility—and that the introduction of derivatives tends to improve the liquidity and informativeness of markets.



Writing in 1688, Joseph de la Vega describes various strategies used by a syndicate of bear traders to manipulate prices in the market for Dutch East India Shares at the Amsterdam Exchange. Some of these tricks involved trading options. For example, de la Vega reports that one strategy employed by the bears was to... ... enter as many put contracts as possible, until the receivers of premiums [assumed to be bulls] do not dare buy more stock [on their own initiative]. [Their hands will be largely tied] because they are already obliged to take the stock [covered by the put premiums, if requested to do so]. Therefore the speculation for the decline has free course and is an almost sure success. Roger Lowenstein, writing in the Wall Street Journal, November 6, 1997, comments: When the Nobel Prize was awarded to the inventors of the formula for pricing stock options, the formula’s practical utility was widely noted. Last Monday, when the market cracked, we saw how practical indeed. To start at the conclusion, the vast growth in the market for options unleashed tremendous selling pressure in the stock market and accentuated Monday’s decline. Previously, the very same options had encouraged stock prices to rise above the level justified by business valuations. The popular assertion that derivative securities tend to destabilize the underlying asset markets has persisted for more than three centuries. To what extent is this notion theoretically justified? To what extent has it been supported by empirical evidence? This topic has been the focus of much academic scrutiny. The purpose of the present article is to provide a comprehensive review of the theoretical and empirical literature on this issue, and more generally on the relationships between


underlying and derivative markets.1 The debate on the effects of derivative trading is closely related to the more fundamental issue of the extent to which speculative trading in general influences market prices. Accordingly, we will begin by reviewing the theoretical literature on speculation and price stability. Much of the early literature in this area focused on the role of speculators in smoothing out seasonal price fluctuations in commodity markets. As we shall see, traditional models of this flavor generally conclude that under certain restrictive assumptions, speculative trading tends to stabilize prices. When these assumptions are violated, it is often found that speculative trading can stabilize or destabilize prices, depending on parameter values. Next, we will discuss several models that explicitly incorporate forward contracting. Again, most of these models were developed in the context of a market for storable commodities. And again, most come to the ambiguous...
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