History And Development Of Derivatives
By Abey Francis
Derivatives refer to a variable, which has been derived from another variable. Interest in derivative products may mostly arise out of Interest in the underlying product, but it can also be without any interest in the underlying. Even if so, the values of derivatives and the underlying are interrelated and irrespective of the fact that one has interest in both or only the later, the two will affect each other prices.
The underlying can be any product, literally anything ranging from agricultural products, foreign exchange, interest rates, oil, gas, gold or silver, stocks and stock indices, financial instruments (Treasury Bills, Bonds, etc.) or anything in the world, which itself is traded. Thus derivatives are derived from markets, products, risks or any underlying on which they are based.
Derivatives have been in use for hundreds of years, in the form of futures or options, when high seas cargoes were bought and sold in future prices (or priced for future delivery) or rice produce sold for future delivery by Japanese farmers. The future transactions were then done in various pockets, in anticipation of future deliveries. The explosion of the market could be linked to or coincided with the collapse of Bretton Woods fixed exchange rate regime (35 USD = 1 Ounce of Gold) and suspension of US Dollars' direct, links to gold in the 1970s. The delinking of US dollars to a fixed parity of gold, effected volatiIity of exchange rates as also the interest rates. The increased volatility thus lead to the creation and explosion of a financial derivatives market which has since than grown manifolds.
In early 1970s, the Chicago Mercantile Exchange introduced the world's first exchange traded currency future contract. Later in 1975, the first interest rate futures were introduced. Several exchanges then introduced exchange rate and interest rate futures contracts. By 1983, the derivative markets saw further growth with currency options trading in Philadelphia Stock Exchange.
Trading in Currency Futures and options gave the world a whole new range of risk management techniques for managing exchange risk, which helped in growth of global trade, investments and cross-border remittances.
This was the time (early 1980s) when interest rate swaps were also introduced. Interest rate swaps helped borrowers and lenders to switch their borrowings/lendings from fixed to floating rate structures are otherwise, as per their views on the interest rate movements.
Mid-1980s saw a boost in the derivatives market, with a host of exchange rate, interest rate as also commodity price risk derivative tools/products being traded in various exchanges, which was evident from the fact that Chicago exchange handled millions of derivatives contracts annually.
Initially, the derivative products were used mainly by the hedgers as actual users of the underlying contracts, who used these products for managing their risks. The importers, exporters, financiers, borrowers, buyers, etc., were the major users of these products.
Gradually, individuals and institutions tracked the prices of derivative products, much similar to speculation in commodity prices or cross currency prices. They started speculation in futures, options and swap prices. This gave depth and volumes to the derivative markets.
Further, there were people who would be always on a look out for, opportunities of mispricing and uneven pricing on the markets, and arbitraged between market differences, until the differences disappeared.
Thus, hedgers, speculations and arbitrages provided depth, volumes and initiative for newer derivative products, so that a large number of exchanges offered these products with spurt in volumes by the day. The derivative products in a short lifespan of 25 years, have seen tremendous growth, which can be observed from the fact that in April 1988, the average daily turnover in derivatives was to the order of USD 1.3 trillion while, the notional amounts outstanding for OTC contracts and exchange traded contracts stood at USD 72 trillion and USD14 trillion respectively in June 1998. (BIS Data):
The main reasons for this growth in derivatives market were increased volatility in the financial and commodity assets during 1970 and 1980s, the oil shocks, in 1971 and thereafter, the need to insulate exchange risk for incomes in different currencies, arising out of increased global investments, technological advancements providing real-time information systems and 24-hour financial trading platforms, also development of pricing models and instruments based on computer-generated work sheets, the political developments and not the least but the most important would be increasing professionalism amongst all market participants, be it banks, traders, actual users, companies, investors, etc.
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