Purpose and Controversies of Derivative Markets

The primary purpose behind derivative contracts is the transfer of risk without the need to trade the underlying. This allows for more effective risk management within companies and the broader economy. In addition, the derivatives market plays a role in information discovery and market efficiency. However, despite the benefits, there are criticisms that derivatives are misused and add to market volatility.

Benefits of Derivative Markets

Information Discovery

The futures market aids in price discovery. Futures prices can be thought of as a forecast of future spot prices, but in reality, they only provide a little more information than the spot price. However, they do so in an efficient manner. A futures price also indicates what price would be acceptable to avoid uncertainty.

In the case of options, one of the characteristics of the asset underlying the option is volatility. Using option pricing models, the volatility of the underlying asset can be determined. This is the volatility implied by the price of the option. The level of implied volatility is a good measure of general uncertainty in the market or a measure of fear.

Operational Advantages

There are some operational advantages to the derivative market:

• Derivatives have lower transaction costs than transacting in the equivalent underlying asset.
• Derivatives markets typically have greater liquidity than the underlying market.
• Derivatives allow short positions to be entered into easily.

Market Efficiency

Markets can be thought of as reasonably efficient. When prices deviate from fundamental values, the derivatives market offers a low-cost way to exploit the mispricing. Less capital is required, transaction costs are lower, and shorting is made possible.

Investors are also far more willing to trade if they know they can manage their risks. This increased willingness to trade increases the number of market participants, which increases market liquidity.

Criticisms of Derivative Markets

Speculation and Gambling

For hedging to work, there must be speculators on the other side of the trade. The more speculators the market attracts, the cheaper it becomes to hedge. Unfortunately, the perception of speculators is not a good one. They are thought to be short-term traders who seek to make a short-term profit and engage in price manipulation and trade at extreme prices. The profit from short-term trading is taxed more heavily than profit from long-term trading – a way of “punishing” these activities.

Many view derivatives trading as a form of legalized gambling; however, there are notable differences. For example, gambling benefits only a limited number of participants. Generally, it does not help society as a whole, while the derivatives market brings extensive benefits to the financial services industry.

Destabilization and Systemic Risk

Opponents of the derivatives market claim the operational benefits result in an excessive amount of speculative trading, bringing instability to the financial markets. They argue that as speculators use large amounts of leverage, they are subjecting themselves and their creditors to high risk if the market moves against them. Defaults by speculators can lead to defaults by their creditors, and these chain-reaction events can be systemic. Instability can, therefore, be spread through the market.

Another criticism of derivatives is their complexity. Although it is unclear why complex mathematics should create criticism, when the models on which derivative pricing is based break down due to sometimes irrational actions by financial market participants, the model builders are often blamed for failing to capture financial market reality accurately.

Question

Which statement best reflects how derivatives are said to destabilize financial markets?

A. Derivatives are highly liquid and expose price inefficiencies

B. Due to the high amounts of leverage embedded in derivatives, losses can be large leading to potential default which can cascade through financial markets

C. Derivatives allow for short transactions which can drive market prices downwards

Solution

The correct answer is B.

The highly leveraged nature of derivatives can lead to large losses resulting in defaults from speculators which are passed on to their creditors. A massive wave of defaults can destabilize financial markets.