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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
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November / December 2012