Derivative markets serve a variety of purposes in global social and economic systems. One of the primary functions of futures markets is price discovery. Futures markets provide valuable information about the prices of the underlying assets on which futures contracts are based. They provide this information in two ways. First, many of these assets are traded in geographically dispersed markets. Recall that the current price of the underlying asset is called the spot price. With geographically dispersed markets, many different spot prices could exist. In the futures markets, the price of the contract with the shortest time to expiration often serves as a proxy for the price of the underlying asset. Second, the prices of all futures contracts serve as prices that can be accepted by those who trade contracts in lieu of facing the risk of uncertain future prices. For example, a company that mines gold can hedge by selling a futures contract on gold expiring in two months, which locks in the price of gold two months later. In this manner, the two-month futures price substitutes for the uncertainty of the price of gold over the next two months.
Futures contracts are not, however, the only derivatives that serve this purpose. In fact, forward contracts and swaps allow users to substitute a single locked-in price for the uncertainty of future spot prices and thereby permit the same form of price discovery as do futures.
Options work in a slightly different manner. They are used in a different form of hedging, one that permits the holder to protect against loss while allowing participation in gains if prices move favorably. Options do not so much reveal prices as they reveal volatility. As we shall see soon, the volatility of the underlying asset is a critical factor in the pricing of options. It is possible, therefore, to infer what investors feel about volatility from the prices of options.
Perhaps the most important purpose of derivative markets is risk management. We define risk management as the process of identifying the desired level of risk, identifying the actual level of risk, and altering the latter to equal the former. Often this process is described as hedging, which generally refers to the reduction, and in some cases the elimination, of risk. On the other side is the process called speculation. Traditional discussions of derivatives refer to hedging and speculation as complementary activities. In general, hedgers seek to eliminate risk and need speculators to assume risk, but such is not always the case. Hedgers often trade with other hedgers, and speculators often trade with other speculators. All one needs to hedge or speculate is a party with opposite beliefs or opposite risk exposure. For example, a corporation that mines gold could hedge the future sale of gold by entering into a derivative transaction with a company that manufactures jewelry. Both of these companies are hedgers, seeking to avoid the uncertainty of future gold prices by locking in a price for a future transaction. The mining corporation has concerns about a price decrease, and the jewelry manufacturer is womed about a price increase.
An unfortunate consequence of the use of the terms “hedging” and “speculating” is that hedgers are somehow seen as on the high moral ground and speculators are sometimes seen as evil-a distortion of the role of speculators. In fact, there need be very little difference between hedgers and speculators. To restate an example we used when discussing swaps, consider a corporation that currently borrows at a floating rate. A common response to a fear of rising interest rates is for the corporation to use an interest rate swap in which it will make payments at a fixed rate and receive payments at a floating rate. The floating-rate payments it receives from the swap offset the floating-rate payments on the loan, thereby effectively converting the loan to a fixed-rate loan. The company is now borrowing at a fixed rate and, in the eyes of many, hedging.
But is the company really hedging? Or is it simply making a bet that interest rates will increase? If interest rates decrease, the company will be losing money in the sense of the lost opportunity to borrow at a lower rate. From a budgeting and cash flow standpoint, however, its fixed interest payments are set in stone. Moreover, the market value of a fixedrate loan is considerably more volatile than that of a floating-rate loan. Thus, our “hedging” corporation can be viewed as taking more risk than it originally had.
The more modem view of the reason for using derivatives does not refer to hedging or speculation. Although we shall sometimes use those terms, we shall use them carefully and make our intentions clear. In the grander scheme of things, derivatives are tools that enable companies to more easily practice risk management. In the context of our corporation borrowing at the floating rate, it made a conscious decision to borrow at a fixed rate. Engaging in the swap is simply an activity designed to align its risk with the risk it wants, given its outlook for interest rates. Whether one calls this activity hedging or speculation is not even very important. The company is simply managing risk.
Derivative markets serve several other useful purposes. As we show later when exploring the pricing of derivative contracts, they improve market efficiency for the underlying assets. Efficient markets are fair and competitive and do not allow one party to easily take money from another. As a simple example, we shall learn in near future buying a stock index fund can be replicated by buying a futures on the fund and investing in risk-free bonds the money that otherwise would have been spent on the fund. In other words, the fund and the combination of the futures and risk-free bond will have the same performance. But if the fund costs more than the combination of the futures and risk-free bond, investors have the opportunity to avoid the overpriced fund and take the combination.18 This decreased demand for the fund will lower its price. The benefits to investors who do not even use derivatives should be clear: They can now invest in the fund at a more attractive price, because the derivatives market forced the price back to its appropriate level.
Derivative markets are also characterized by relatively low transaction costs. For example, the cost of investing in a stock index portfolio is as much as 20 times the cost of buying a futures contract on the index and a risk-free bond as described above. One might reasonably ask why derivatives are so much less expensive in terms of transaction costs. The answer is that derivatives are designed to provide a means of managing risk. As we have previously described, they serve as a form of insurance. Insurance cannot be a viable product if its cost is too high relative to the value of the insured asset. In other words, derivatives must have low transaction costs; otherwise, they would not exist. It would be remiss to overlook the fact that derivative markets have been subject to many criticisms. We next present some of these complaints and the reasons behind them.
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