Innovative risk management tools, a speculator’s dream, is one of
many expressions used to describe derivatives and for a long time in
the late twentieth century many were not particularly complimentary!
Strange that this should be the case given that the purpose of a
derivative product is to transfer risk from a party wishing to remove
a risk to a party willing to take on the risk with a view to making a
profit. Derivatives bring stability to all types of markets, reducing the
need to sell assets and commodities in falling markets by preventing
losses when such a fall occurs. As long ago as the Middle Ages
derivative-type transactions took place so the product is not new. In
1848 the derivative markets we see today really began when the
Chicago Board of Trade was established and standardized contracts,
called futures, for commodities were created.
The standardization of the terms of a transaction into a contract
enabled that contract to be freely traded. If a farmer purchased a
grain contract he could subsequently sell this to someone else and
remove the obligation created by the trades by having an offsetting
long and short position, which could be closed out. As contracts were
for the delivery of grain and were a legally binding obligation to do so
on both the buyer and the seller this was an important feature. So too
was the guarantee offered by the clearing house of the exchange
which ensured that delivery would be honoured and that the grade of
commodity delivered would meet the required specification. Coupled
with the ability to discover the true price of the commodity as buyers
and sellers gathered to trade on the market floor generating liquidity,
it was of little surprise that success came quickly and within years
other similar markets trading a range of commodities opened in the
USA.
The scene remained much the same until the mid-1970s when
financial futures contracts were introduced. From then on volumes of
contracts traded on exchanges, which now numbered hundreds and
were worldwide, grew at a fantastic rate. By the end of 2001 volumes
were over 3 billion and rising. It is important to recognize that
derivatives are not just traded on exchanges. In fact prior to 1848
‘derivatives’ were traded in the form of forward contracts and
options. They were deals made between two parties and were
transacted off-exchange, in other words there were no rules or
regulations governing the deal and the terms were simply negotiated
to suit both parties. While this type of trade was common there were
large, and growing problems, with one or other party defaulting on
their obligations and also with establishing the ‘true’ price for the
deal. The Chicago Board of Trade was established to remove these
problems and did so with the introduction of the standardized futures
contract, which we recognize today.
The problem, if that is the right word, with derivatives is that when
use of them is made without understanding what they are designed to
do, or when their use is unauthorized or uncontrolled, then losses can
and do occur. However, we should focus on the positive side of
derivatives while respecting the need to understand the characteristics
and potential risk associated with the product.
Derivatives transfer risk from those who wish to avoid or disperse the
risk to those who wish to assume the risk with a view to profiting from
the characteristics. With that basic concept we need to understand
why the product is attractive to both hedgers (those who wish to get
rid of risk) and speculators who wish to profit from their use.
Read More : Derivatives and commodities markets
