Derivatives. Pirie Wendy L.

options expire out of the money.

      The OTC industry has taken both of these concepts – notional principal and market value – as measures of the size of the market. Notional principal is probably a more accurate measure. The amount of a contract’s notional principal is unambiguous: It is written into the contract and the two parties cannot disagree over it. Yet, notional principal terribly overstates the amount of money actually at risk. For example, a $50 million notional principal swap will have nowhere near $50 million at risk. The payments on such a swap are merely the net of two opposite series of interest payments on $50 million. The market value of such a swap is the present value of one stream of payments minus the present value of the other. This market value figure will always be well below the notional principal. Thus, market value seems like a better measure except that, unlike notional principal, it is not unambiguous. Market value requires measurement, and two parties can disagree on the market value of the same transaction.

      Notional principal and market value estimates for the global OTC derivatives market are collected semi-annually by the Bank for International Settlements of Basel, Switzerland, and published on its website (http://www.bis.org/statistics/derstats.htm). At the end of 2011, notional principal was more than $600 trillion and market value was about $27 trillion. A figure of $600 trillion is an almost unfathomable number and, as noted, is a misleading measure of the amount of money at risk.18 The market value figure of $27 trillion is a much more realistic measure, but as noted, it is less accurate, relying on estimates provided by banks.

      Hence, the exchange-listed and OTC markets use different measures and each of those measures is subject to severe limitations. About all we can truly say for sure about the derivatives market is, “It is big.”

      5. THE PURPOSES AND BENEFITS OF DERIVATIVES

      Economic historians know that derivatives markets have existed since at least the Middle Ages. It is unclear whether derivatives originated in the Asian rice markets or possibly in medieval trade fairs in Europe. We do know that the origin of modern futures markets is the creation of the Chicago Board of Trade in 1848. To understand why derivatives markets exist, it is useful to take a brief look at why the Chicago Board of Trade was formed.

      In the middle of the 19th century, midwestern America was rapidly becoming the center of agricultural production in the United States. At the same time, Chicago was evolving into a major American city, a hub of transportation and commerce. Grain markets in Chicago were the central location to which midwestern farmers brought their wheat, corn, and soybeans to sell. Unfortunately, most of these products arrived at approximately the same time of the year, September through November. The storage facilities in Chicago were strained beyond capacity. As a result, prices would fall tremendously and some farmers reportedly found it more economical to dump their grains in the Chicago River rather than transport them back to the farm. At other times of the year, prices would rise steeply. A group of businessmen saw this situation as unnecessary volatility and a waste of valuable produce. To deal with this problem, they created the Chicago Board of Trade and a financial instrument called the “to-arrive” contract. A farmer could sell a to-arrive contract at any time during the year. This contract fixed the price of the farmer’s grain on the basis of delivery in Chicago at a specified later date. Grain is highly storable, so farmers can hold on to the grain and deliver it at almost any later time. This plan substantially reduced seasonal market volatility and made the markets work much better for all parties.

      The traders in Chicago began to trade these contracts, speculating on movements in grain prices. Soon, it became apparent that an important and fascinating market had developed. Widespread hedging and speculative interest resulted in substantial market growth, and about 80 years later, a clearinghouse and a performance guarantee were added, thus completing the evolution of the to-arrive contract into today’s modern futures contract.

      Many commodities and all financial assets that underlie derivatives contracts are not seasonally produced. Hence, this initial motivation for futures markets is only a minor advantage of derivatives markets today. But there are many reasons why derivative markets serve an important and useful purpose in contemporary finance.

      5.1. Risk Allocation, Transfer, and Management

      Until the advent of derivatives markets, risk management was quite cumbersome. Setting the actual level of risk to the desired level of risk required engaging in transactions in the underlyings. Such transactions typically had high transaction costs and were disruptive of portfolios. In many cases, it is quite difficult to fine-tune the level of risk to the desired level. From the perspective of a risk taker, it was quite costly to buy risk because a large amount of capital would be required.

      Derivatives solve these problems in a very effective way: They allow trading the risk without trading the instrument itself. For example, consider a stockholder who wants to reduce exposure to a stock. In the pre-derivatives era, the only way to do so was to sell the stock. Now, the stockholder can sell futures, forwards, calls, or swaps, or buy put options, all while retaining the stock. For a company founder, these types of strategies can be particularly useful because the founder can retain ownership and probably board membership. Many other excellent examples of the use of derivatives to transfer risk are covered elsewhere in the curriculum. The objective at this point is to establish that derivatives provide an effective method of transferring risk from parties who do not want the risk to parties who do. In this sense, risk allocation is improved within markets and, indeed, the entire global economy.

      The overall purpose of derivatives is to obtain more effective risk management within companies and the entire economy. Although some argue that derivatives do not serve this purpose very well (we will discuss this point in Section 6), for now you should understand that derivatives can improve the allocation of risk and facilitate more effective risk management for both companies and economies.

      5.2. Information Discovery

      One of the advantages of futures markets has been described as price discovery. A futures price has been characterized by some experts as a revelation of some information about the future. Thus, a futures price is sometimes thought of as predictive. This statement is not strictly correct because futures prices are not really forecasts of future spot prices. They provide only a little more information than do spot prices, but they do so in a very efficient manner. The markets for some underlyings are highly decentralized and not very efficient. For example, what is gold worth? It trades in markets around the world, but probably the best place to look is at the gold futures contract expiring soonest. What is the value of the S&P 500 Index when the US markets are not open? As it turns out, US futures markets open before the US stock market opens. The S&P 500 futures price is frequently viewed as an indication of where the stock market will open.

      Derivative markets can, however, convey information not impounded in spot markets. By virtue of the fact that derivative markets require less capital, information can flow into the derivative markets before it gets into the spot market. The difference may well be only a matter of minutes or possibly seconds, but it can provide the edge to astute traders.

      Finally, we should note that futures markets convey another simple piece of information: What price would one accept to avoid uncertainty? If you hold a stock worth $40 and could hedge the next 12 months’ uncertainty, what locked-in price should you expect to earn? As it turns out, it should be the price that guarantees the risk-free rate minus whatever dividends would be paid on the stock. Derivatives – specifically, futures, forwards, and swaps – reveal the price that the holder of an asset could take and avoid the risk.

      What we have said until now applies to futures, forwards, and swaps. What about options? As you will learn later, given the underlying and the type of option (call or put), an option price reflects two characteristics of the option (exercise price and time to expiration), three characteristics of the underlying (price, volatility, and cash flows it might pay), and one general macroeconomic factor (risk-free rate). Only one of these factors, volatility, is not relatively easy to identify. But with the available models to price the option, we can infer what volatility people are using from the actual market