Derivatives. Pirie Wendy L.

at which they execute trades. That volatility, called implied volatility, measures the expected risk of the underlying. It reflects the volatility that investors use to determine the market price of the option. Knowing the expected risk of the underlying asset is an extremely useful piece of information. In fact, for options on broad-based market indices, such as the S&P 500, the implied volatility is a good measure of the general level of uncertainty in the market. Some experts have even called it a measure of fear. Thus, options provide information about what investors think of the uncertainty in the market, if not their fear of it.19

      In addition, options allow the creation of trading strategies that cannot be done by using the underlying. As the exhibits on options explained, these strategies provide asymmetrical performance: limited movement in one direction and movement in the other direction that changes with movements in the underlying.

      5.3. Operational Advantages

      We noted earlier that derivatives have lower transaction costs than the underlying. The transaction costs of derivatives can be high relative to the value of the derivatives, but these costs are typically low relative to the value of the underlying. Thus, an investor who wants to take a position in, say, an equity market index would likely find it less costly to use the futures to get a given degree of exposure than to invest directly in the index to get that same exposure.

      Derivative markets also typically have greater liquidity than the underlying spot markets, a result of the smaller amount of capital required to trade derivatives than to get the equivalent exposure directly in the underlying. Futures margin requirements and option premiums are quite low relative to the cost of the underlying.

      One other extremely valuable operational advantage of derivative markets is the ease with which one can go short. With derivatives, it is nearly as easy to take a short position as to take a long position, whereas for the underlying asset, it is almost always much more difficult to go short than to go long. In fact, for many commodities, short selling is nearly impossible.

      5.4. Market Efficiency

      In the study of portfolio management, you learn that an efficient market is one in which no single investor can consistently earn returns in the long run in excess of those commensurate with the risk assumed. Of course, endless debates occur over whether equity markets are efficient. No need to resurrect that issue here, but let us proceed with the assumption that equity markets – and, in fact, most free and competitive financial markets – are reasonably efficient. This assumption does not mean that abnormal returns can never be earned, and indeed prices do get out of line with fundamental values. But competition, the relatively free flow of information, and ease of trading tend to bring prices back in line with fundamental values. Derivatives can make this process work even more rapidly.

      When prices deviate from fundamental values, derivative markets offer less costly ways to exploit the mispricing. As noted earlier, less capital is required, transaction costs are lower, and short selling is easier. We also noted that as a result of these features, it is possible, indeed likely, that fundamental value will be reflected in the derivatives markets before it is restored in the underlying market. Although this time difference could be only a matter of minutes, for a trader seeking abnormal returns, a few minutes can be a valuable opportunity.

      All these advantages of derivatives markets make the financial markets in general function more effectively. Investors are far more willing to trade if they can more easily manage their risk, trade at lower cost and with less capital, and go short more easily. This increased willingness to trade increases the number of market participants, which makes the market more liquid. A very liquid market may not automatically be an efficient market, but it certainly has a better chance of being one.

      Even if one does not accept the concept that financial markets are efficient, it is difficult to say that markets are not more effective and competitive with derivatives. Yet, many blame derivatives for problems in the market. Let us take a look at these arguments.

6. CRITICISMS AND MISUSES OF DERIVATIVES

      The history of financial markets is filled with extreme ups and downs, which are often called bubbles and crashes. Bubbles occur when prices rise for a long time and appear to exceed fundamental values. Crashes occur when prices fall rapidly. Although bubbles, if they truly exist, are troublesome, crashes are even more so because nearly everyone loses substantial wealth in a crash. A crash is then typically followed by a government study commissioned to find the causes of the crash. In the last 30 years, almost all such studies have implicated derivatives as having some role in causing the crash. Of course, because derivatives are widely used and involve a high degree of leverage, it is a given that they would be seen in a crash. It is unclear whether derivatives are the real culprit or just the proverbial smoking gun used by someone to do something wrong.

      The two principal arguments against derivatives are that they are such speculative devices that they effectively permit legalized gambling and that they destabilize the financial system. Let us look at these points more closely.

      6.1. Speculation and Gambling

      As noted earlier, derivatives are frequently used to manage risk. In many contexts, this use involves hedging or laying off risk. Naturally, for hedging to work, there must be speculators. Someone must accept the risk. Derivatives markets are unquestionably attractive to speculators. All the benefits of derivatives draw speculators in large numbers, and indeed they should. The more speculators that participate in the market, the cheaper it is for hedgers to lay off risk. These speculators take the form of hedge funds and other professional traders who willingly accept risk that others need to shed. In recent years, the rapid growth of these types of investors has been alarming to some but almost surely has been beneficial for all investors.

      Unfortunately, the general image of speculators is not a good one. Speculators are often thought to be short-term traders who attempt to exploit temporary inefficiencies, caring little about long-term fundamental values. The profits from short-term trading are almost always taxed more heavily than the profits from long-term trading, clearly targeting and in some sense punishing speculators. Speculators are thought to engage in price manipulation and to trade at extreme prices.20 All of this type of trading is viewed more or less as just a form of legalized gambling.

      In most countries, gambling is a heavily regulated industry. In the United States, only certain states permit private industry to offer gambling. Many states operate gambling only through the public sector in the form of state-run lotteries. Many people view derivatives trading as merely a form of legalized and uncontrolled gambling.

      Yet, there are notable differences between gambling and speculation. Gambling typically benefits only a limited number of participants and does not generally help society as a whole. But derivatives trading brings extensive benefits to financial markets, as explained earlier, and thus does benefit society as a whole. In short, the benefits of derivatives are broad, whereas the benefits of gambling are narrow.

      Nonetheless, the argument that derivatives are a form of legalized gambling will continue to be made. Speculation and gambling are certainly both forms of financial risk taking, so these arguments are not completely off base. But insurance companies speculate on loss claims, mutual funds that invest in stocks speculate on the performance of companies, and entrepreneurs go up against tremendous odds to speculate on their own ability to create successful businesses. These so-called speculators are rarely criticized for engaging in a form of legalized gambling, and indeed entrepreneurs are praised as the backbone of the economy. Really, all investment is speculative. So, why is speculation viewed as such a bad thing by so many? The answer is unclear.

      6.2. Destabilization and Systemic Risk

      The arguments against speculation through derivatives often go a step further, claiming that it is not merely speculation or gambling per se but rather that it has destabilizing consequences. Opponents of derivatives claim that the very benefits of derivatives (low cost, low capital requirements, ease of going short) result in an excessive amount of speculative trading that brings instability to the market. They argue that speculators use large amounts of leverage, thereby subjecting

19

The Chicago Board Options Exchange publishes a measure of the implied volatility of the S&P 500 Index option, which is called the VIX (volatility index). The VIX is widely followed and is cited as a measure of investor uncertainty and sometimes fear.

20

Politicians and regulators have been especially critical of energy market speculators. Politicians, in particular, almost always blame rising oil prices on speculators, although credit is conspicuously absent for falling oil prices.