Derivative securities are financial instruments whose earliest beginnings can be traced to 17th-century 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.