Derivatives. Pirie Wendy L.

instability can spread throughout markets and an economy, if not the entire world. Given that governments often end up bailing out some banks and insurance companies, society has expressed concern that the risk managed with derivatives must be controlled.

      This argument is not without merit. Such effects occurred in the Long-Term Capital Management fiasco of 1998 and again in the financial crisis of 2008, in which derivatives, particularly credit default swaps, were widely used by many of the problem entities. Responses to such events typically take the course of calling for more rules and regulations restricting the use of derivatives, requiring more collateral and credit mitigation measures, backing up banks with more capital, and encouraging, if not requiring, OTC derivatives to be centrally cleared like exchange-traded derivatives.

      In response, however, we should note that financial crises – including the South Sea and Mississippi bubbles and the stock market crash of 1929, as well as a handful of economic calamities of the 19th and 20th centuries – have existed since the dawn of capitalism. Some of these events preceded the era of modern derivatives markets, and others were completely unrelated to the use of derivatives. Some organizations, such as Orange County, California, in 1994–1995, have proved that derivatives are not required to take on excessive leverage and nearly bring the entity to ruin. Proponents of derivatives argue that derivatives are but one of many mechanisms through which excessive risk can be taken. Derivatives may seem dangerous, and they can be if misused, but there are many ways to take on leverage that look far less harmful but can be just as risky.

      Another criticism of derivatives is simply their complexity. Many derivatives are extremely complex and require a high-level understanding of mathematics. The financial industry employs many mathematicians, physicists, and computer scientists. This single fact has made many distrust derivatives and the people who work on them. It is unclear why this reason has tarnished the reputation of the derivatives industry. Scientists work on complex problems in medicine and engineering without public distrust. One explanation probably lies in the fact that scientists create models of markets by using scientific principles that often fail. To a physicist modeling the movements of celestial bodies, the science is reliable and the physicist is unlikely to misapply the science. The same science applied to financial markets is far less reliable. Financial markets are driven by the actions of people who are not as consistent as the movements of celestial bodies. When financial models fail to work as they should, the scientists are often blamed for either building models that are too complex and unable to accurately capture financial reality or misusing those models, such as using poor estimates of inputs. And derivatives, being so widely used and heavily leveraged, are frequently in the center of it all.

      EXAMPLE 6 Purposes and Controversies of Derivative Markets

      1. Which of the following is not an advantage of derivative markets?

      A. They are less volatile than spot markets.

      B. They facilitate the allocation of risk in the market.

      C. They incur lower transaction costs than spot markets.

      2. Which of the following pieces of information is not conveyed by at least one type of derivative?

      A. The volatility of the underlying.

      B. The most widely used strategy of the underlying.

      C. The price at which uncertainty in the underlying can be eliminated.

      3. Which of the following responds to the criticism that derivatives can be destabilizing to the underlying market?

      A. Market crashes and panics have occurred since long before derivatives existed.

      B. Derivatives are sufficiently regulated that they cannot destabilize the spot market.

      C. The transaction costs of derivatives are high enough to keep their use at a minimum level.

      Solution to 1: A is correct. Derivative markets are not by nature more or less volatile than spot markets. They facilitate risk allocation by making it easier and less costly to transfer risk, and their transaction costs are lower than those of spot markets.

      Solution to 2: B is correct. Options do convey the volatility of the underlying, and futures, forwards, and swaps convey the price at which uncertainty in the underlying can be eliminated. Derivatives do not convey any information about the use of the underlying in strategies.

      Solution to 3: A is correct. Derivatives regulation is not more and is arguably less than spot market regulation, and the transaction costs of derivatives are not a deterrent to their use; in fact, derivatives are widely used. Market crashes and panics have a very long history, much longer than that of derivatives.

      An important element of understanding and using derivatives is having a healthy respect for their power. Every day, we use chemicals, electricity, and fire without thinking about their dangers. We consume water and drive automobiles, both of which are statistically quite dangerous. Perhaps these risks are underappreciated, but it is more likely the case that most adults learn how to safely use chemicals, electricity, fire, water, and automobiles. Of course, there are exceptions, many of which are foolish, and foolishness is no stranger to the derivatives industry. The lesson here is that derivatives can make our financial lives better, but like chemicals, electricity, and all the rest, we need to know how to use them safely, which is why they are an important part of the CFA curriculum.

      1

      Unfortunately, English financial language often evolves without regard to the rules of proper usage. Underlying is typically an adjective and, therefore, a modifier, but the financial world has turned it into a noun.

      2

      In the financial world, the long always benefits from an increase in the value of the instrument he owns, and the short always benefits from a decrease in the value of the instrument he has sold. Think of the long as having possession of something and the short as having incurred an obl

1

Unfortunately, English financial language often evolves without regard to the rules of proper usage. Underlying is typically an adjective and, therefore, a modifier, but the financial world has turned it into a noun.

2

In the financial world, the long always benefits from an increase in the value of the instrument he owns, and the short always benefits from a decrease in the value of the instrument he has sold. Think of the long as having possession of something and the short as having incurred an obligation to deliver that something.

3

It is important to understand that merely being able to buy and sell a derivative, or even a security, does not mean that liquidity is high and that the cost of liquidity is low. Derivatives exchanges guarantee that a derivative can be bought and sold, but they do not guarantee the price. The ask price (the price at which the market maker will sell) and the bid price (the price at which the market maker will buy) can be far apart, which they will be in a market with low liquidity. Hence,