Rationale for Derivatives Markets
A Brief Review of Why Efficient Markets Need Derivatives
Whether it is price discovery, risk management, or low transaction costs, derivative markets have a wide range of roles in social and economic systems worldwide.
Regardless whether derivatives markets are measured by their notional value or their market value, the size of the derivatives industry is massive by anyone’s standard. Since derivatives can exist on their own, or can be embedded in nearly all asset classes in some shape or form, prudent investors are likely to benefit from understanding the rationale behind derivatives, even if they may choose to stay away from them.
Price Discovery
One of the main purposes of futures markets is price discovery. Note that this function refers to the informational value contained in prices of the underlying assets, based on which futures contracts were created. The manner in which prices of the underlying assets provide informational value is twofold.
First, futures markets exist all over the world. Having geographical dispersion in mind, note that the current price of a futures contract is referred to as its spot price. Since futures trade in many global markets, many spot prices exist. Typically, the spot price of a futures contract with the shortest time to expiry is perceived as a proxy for the price of the underlying asset.
Second, futures spot prices serve as prices that buyers are willing to pay and sellers are willing to accept, having in mind the risk exposure to future price volatility. For example, a nickel mining company may decide to lock in prices three months in advance by entering into a futures contract. By setting up this hedge transaction, the nickel miner is protecting current production from future price volatility.
Of course, futures contracts are not the only type of derivatives that fulfill the role of price discovery. Forward contracts and swaps also allow investors to lock in prices today to protect their underlying assets against unfavorable price movements in the future.
Note that options operate in a somewhat different manner. While forward commitments can reveal valuable price information about the underlying assets, options focus more on revealing the information about the level of volatility of the underlying. This is because options represent a different form of hedging, as they allow option holders to avoid potential losses while equally enjoying the potential for profits.
Risk Management
Economic theory defines risk management as the process whereby a prudent person first ascertains the acceptable level of risk, then estimates the actual level of risk, and then tries to adjust the actual level of risk to match as closely as possible the acceptable level of risk. This process is also referred to as hedging, risk reduction, and in some cases, even risk elimination.
But for the process of risk management to work in real life, hedgers need someone on the other side of a transaction to assume the unwanted risk. Which is to say, they need speculators. Traditional views of derivatives trading perceive hedging and speculating as one complementing the other. In reality, of course, hedgers and speculators’ roles are not always clear-cut.
For example, a company that is mining diamonds can enter into a hedge transaction with a jewelry manufacturer. Both parties are hedgers, whereby the mining company is worried about the price decrease, while the jeweler is worried about diamonds’ price increase.
Other Purposes of Derivatives Markets
Generally speaking, derivatives markets improve market efficiency of the underlying assets. In efficient markets, prices are for the most part fair and based on legitimate market forces. In other words, one party cannot unfairly take money from the other, at least not easily.
Also, as financial instruments, derivatives have relatively low transaction costs. This is because derivatives have been designed primarily as risk management tools. Imagine buying an insurance policy that is too expensive to justify any protection that the policy might offer. Meaning, if derivatives did not have low transaction costs, there would be no buyers and sellers, and the market for them would simply cease to exist.
