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Depression was history, rather than a current worry. One might add other risks: rioting over debt and taxes as seen in Greece, or natural disasters that clobber the economy such as the March 2011 earthquake and tsunami in Japan. If the premiums were reasonable, many of us would consider insuring our net worth. The rising interest in tail-risk hedging suggests a bull market in such insurance. But the truth is, in one sense, we are all being paid that premium to accept many of the unknown, and unquantifiable, risks. There is a long-debated puzzle about the equity risk premium (ERP)—the extra return one expects from holding a risky stock instead of a Treasury bill—why does it seem as large as 3 to 5 percent or more? Research by Robert Barro 4 argues that the ERP is compensation for accepting a small risk of a truly catastrophic event. An example might be a war that would close markets for several years and devastate an economy. Barro estimates the probability of such catastrophic events and then links this to an individual’s utility function to show that the degree of risk aversion is reasonable. Through the market, the ERP is compensating investors for risks they are facing through their investors. The ERP means that each investor writes a put option on his entire investment holdings and then sells it to himself. He accepts the risks and receives the premiums. The market sets the premium. Writing and buying this put is mandatory if an investor participates in the market. Those other options—from the Dutch East India Company to an option on the S&P 500 Index—are voluntary, not mandatory. A major benefit of options embracing quant models is that the range of options and quantitative tools has expanded greatly since Black-Scholes. Two examples familiar to index investors are options on indexes led by the S&P 500 and VIX. A put on the S&P 500 is not the same as a put option on one’s entire net worth, but it is a lot more comprehensive than a put on a single stock. VIX comes full circle in offering new ways to use options to protect, or invest, in the market while returning information to the market from options priced in the market. Much remains that can be done with options to give people ways to insure or accept risks. Ten years ago, we all thought that real estate prices rarely drop. Now the idea of insuring the economic value of one’s home looks attractive. One idea is to use the S&P/Case-Shiller Home Price indexes puts for homeowners or calls for investors on home values. If one can insure against fire, it only makes sense to insure against a market collapse. What does this all have to do with Amsterdam and Black-Scholes? Only this: Derivatives are thought of by some as weapons of financial mass destruction, a “new new thing” that contributed to the financial crisis and that are dangerous in the hands of unknowing investors. But from another perspective, options—and optionslinked products like the VIX—have been with us for centuries, and used properly, have the opposite effect. Like the old traders who used options on the Dutch East India Company because they couldn’t handle the risk of owning the stock, they are a way of limiting our downside, insuring against shipwrecks and protecting our portfolios from harm. Endnotes 1 Black, Fischer and Myron Scholes, “The Pricing of Options and Corporate Liabilities,” 81(3) Journal of Political Economy, 1973, pp. 637-654. 2 Geoffrey Poitras, “The Early History of Option Contracts,” Simon Fraser University, September 2008. 3 William N. Goetzmann and K. Geert Rouwenhorst, “The Origins of Value,” Oxford University Press, September 2008. 4 Robert Barro, “Rare Events and the Equity Risk Premium,” Harvard University, July 2005. Why subscribe to the The Journal of Indexes is the premier source for financial index research, news and data. Written by and for industry experts and financial practitioners, it is the book of record for the index industry. Browse content online at www.indexuniverse.com/JOI TO SUBSCRIBE, VISIT: www.indexuniverse.com/JOI/subscriptions Redefining Credit Risk William Mast Credit Derivatives Indexes Gavan Nolan and Tobias Sproehnle A Fixed-Income Roundtable Ken Volpert, Jason Hsu, Waqas Samad, Larry Swedroe and more The Impact of Bond Fund Flows David Blanchett Plus David Blitzer on bubbles, Jeremy Schwartz on dividends and buybacks, Francis Gupta on country classifications and a biography on Bogle www.journalofindexes.com November / December 2012 35
On Derivatives Human Risk And The Pervasiveness Of Index-Based Derivatives The dark side of innovation By Jonathan Citrin Derivative securities are financial instruments whose earliest beginnings can be traced to 17thcentury tulip bulbs in Holland and rice in Japan (Calistru 2011). Derivatives—contracts specifying a transaction in an underlying asset to be fulfilled at a future date—found favor in the markets during the last quarter of the 20th century. They are investment vehicles whose goal was to mitigate risk in otherwise-volatile commodity, currency, interest-rate and equity markets. Following their acceptance by mainstream market participants, derivatives became a common topic of discussion and research throughout the field of finance. Interestingly, from their early days of use to the major market role they play today, there has been very little agreement concerning the impact of derivatives on markets and economies of the world. In fact, the initial raison d’être (for hedging purposes) is perhaps the only point of universal consensus amongst academics, professionals and policymakers. “[They] are mainly used to protect against and manage risk,” (Deutsche Börse Group 2005). “The key function of derivatives is to hedge the risk inherent in the underlying markets, in order to guard against changes in interest and exchange rates, fluctuations in commodity prices and so on,” (Hawkesby 1999). And, “The need for market completeness has generated the need to create some financial instruments that will allow investors to hedge and thus, to be secured from price fluctuations” (Siopis 2007). The spike in use of derivatives finds root in the changing global marketplace of the 1970s after policy alterations motivated market participants to find alternative means for mitigating volatility’s impact on corporate operations. “The demand for financial products to manage risk was increased by soaring international trade and capital flows. Derivatives seem to meet best the new challenges of financial markets,” (Calistru 2011). Secondary uses of derivatives include speculation and arbitrage; however, the main force behind the development and increasing use remains true to their original purpose—controlling the downside risk of portfolios and balance sheets. Figure 1 illustrates the great rise in use of derivatives over the later 20th and early 21st centuries. More specifically, index-based derivatives represent contracts whose settlement is facilitated in cash and determined by the price at expiration of an underlying index (e.g., Standard & Poor’s 500 Index options (SPX): inception July 1, 1983, and Dow Jones Industrial Average options (DJX): inception Oct. 6, 1997) (CBOE 2012). True to their beginnings, undisputed attributes of index-based derivatives include: 1) leverage, 2) arbitrage, 3) reduction in bid/ask spread, 4) liquidity, 5) increased participation in underlying markets, 6) low transaction costs, 7) transparency, 8) innovation, and 9) flexibility in product design. However, despite agreement on these key characteristics, academic and professional research yields many varying conclusions and even dissimilarity in empirical evidence with regard to the impact of index-based derivatives on underlying market volatility. The influence of index-based derivatives on underlying assets has been a source of great discord through recent history and may never be agreed upon. Significant evidence exists that both favors and condemns the influence of indexbased derivatives on the investments they track. Much recent research, time and money has been spent disputing the effect of index-based derivatives on the volatility of underlying indexes, not to mention considerable efforts expended to determine the role of index-based derivatives in major market crashes, including the Great Recession of 2008 and October 1987’s Black Monday. However, commentary on and 36 November / December 2012
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Page 14 and 15: Figure 5 Median notional Volume ($B
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