Derivatives are one of the most modern types of financial instruments. They first appeared in the 19th century, while they were fully structured in the international markets during the 20th century, initially in the United States. Derivatives, by definition, comprise financial securities with values reliant upon, or derived from, an underlying asset or a group of assets. There is a wide variety of assets that can be used in the derivatives market such as commodities, stocks, bonds, currencies and interest rates, among other even more complicated instruments. The most widespread types of derivatives are futures, forwards, swaps and options, which can both be exchange traded or over the counter (not within an organized market). This article attempts to explain the basic opportunities and dangers of derivative contracts for both individual investors and the financial markets.
Over time, financial derivatives have proven to be really useful for hedging operations, while they have created additional opportunities for speculation and arbitrage, the simultaneous buying and selling of financial products in order to take advantage of different prices for the same asset. For example, the increased price volatility of commodities, currency and securities enhanced the desire for risk management. Various economic agents are involved, including banking institutions, big corporations and manufacturers. The relatively low transactional costs for trading derivatives, the potential of a quick withdrawal from negative positions and the potential benefits of leveraged positions make this market quite useful in this process. Its interaction with the spot market may also create arbitrage opportunities which can be exploited by experienced traders, enhancing market effectiveness at the same time.
Therefore, in a greater market perspective, derivatives play a major role in the completion and efficiency of the international financial system. Their market has contributed to decreased price volatility and effective price discovery. It has been estimated that financial markets integrate new information faster under a strong derivatives market rather than in its absence. Derivatives markets absorb new information first, which then affect spot market prices. In most cases, there is a lead-lag relation between forward and spot prices, which remain interconnected. As a result, forward or future prices can be used for more accurate forecasts of spot market’s course, driving traders in a way that stabilizes the spot market towards the fair prices and an equilibrium.
Their acknowledged benefits to both investors and the financial markets, though, don’t come without significant costs or dangers. At the first place, when it comes to the risks, investing in derivatives means high leverage investment positions which can lead to potentially huge losses. In comparison to primary securities, these contracts can lead to impressive gains with a minimum investment using leverage. However, if prices move towards the opposite direction, higher leveraged losses are recorded. We can call them a high risk- high reward type of investment. That’s why derivative markets are mostly exploited for hedging and arbitrage by institutional investors and experienced traders who can identify dangers and minimize the risks taken. They are considered to be a rather complex market for retail investors that requires advanced knowledge to be used efficiently.
More importantly, derivatives have been the main source of the 2008 financial crisis. When the housing market prices collapsed leading to unpaid mortgages, this collapse quickly moved into the international markets through proliferated and unregulated derivative contracts based on packages of mortgages. This was a surprise for the markets as these contracts maintained strong credit ratings by major credit rating institutions like Fitch, Moody’s and Standard & Poor’s, boosting the global market’s shock. Also given the lead-lag relation between derivatives and spot markets, the pressures put on the derivatives market immediately affected the spot market and specifically the stock market. Following the collapse of big US banks, such as Lehman Brothers, the market went crazy recording unprecedented losses that can only be compared to the 1929 crisis, vanishing investing confidence for years.
Taking everything into account, we can understand that derivatives are particularly beneficial for both traders and the international markets, but they need to be used carefully and under a specific protective framework due to the increased risks they entail. There have been efforts to reduce the market and credit risk of derivatives, accompanied by additional regulation on the quality of contracts and their introduction into the market. Overall, this market seems to be in the right direction after the 2008 crisis, contributing to the efficiency of financial markets and risk management operations necessary in the modern economy.