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.
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