Economic Functions:

Futures and options perform very useful economic functions: risk transfer, price discovery, and market completion.

Risk Transfer: By themselves, derivatives do not create additional risk. They merely reallocate the existing risk among various participants in the financial markets. In this sense, they are like insurance products.

The combined set of futures and options contracts and the markets, formal and informal, in which they are transferred has thus been likened to a gigantic insurance company and rightly so. Efficient risk sharing is what much of the futures and options revolution has been all about.

Price Discovery: Individuals possessing superior information and judgment are motivated to participate in the futures markets as well as the options market. These markets are a way to distill and convey information about what is likely to happen. They improve price discovery (as prices reflect more information). This leads to a better allocation of resources.

Market Completion: In a complete market, the number of independent securities (or financial instruments) equals the number of alternative future states of nature. This means that it is possible to draw up financial contracts which cover all possible contingencies.

A complete market is a theoretical ideal that is not attainable in practice. It is not possible to design enforceable financial contracts that cover an endless range of contingencies. While a complete market is an impractical proposition, it is possible to increase the degree of market completeness by adding more instruments. Futures and options certainly represent useful instruments that expand the opportunities available to the investors at fairly low transaction costs.

Thanks to the valuable economic functions performed by the derivatives, they have come to play an important role in the financial markets all over the world. This is evident from the global explosion in the volume of derivative trading.

Critique and Response:

Notwithstanding the endorsement of derivatives by financial economists and business persons, there is a widespread belief among regulators, bureaucrats, and politicians that derivatives are employed mainly for gambling or speculation purposes, and they accentuate the volatility in the underlying cash markets.

Futures and options are the tail wagging the dog. They have escalated the leverage and volatility of the markets to precipitous, unacceptable levels.

In support of their contention, the critics cases of organizations which have suffered grievously from the use derivatives. Some such examples are the German conglomerate giant Metallgesellschaft, Orange County, and Barings Plc.

The Barings Episode:

While derivatives are mostly used for risk hedging, they may be used for speculation as well. A recent and conspicuous example is the reckless purchase of futures contracts on Japan’s Nikkei index by Nicholas Leeson, which lead to the collapse of Barings Plc. Leeson took a bet that the Nikkei index would rise. Contrary to his expectations, the Nikkei index fell precipitously, entailing a huge loss. While the truth in the Barings case is not fully known, it appears that the debacle was caused by a combination of several factors, namely, recklessness of a rogue trader (Nicholas Leeson), camouflaging of transactions, inability of the auditor to raise the right questions, inadequate controls, and connivance on the part of the top management.

It is important to note that the Barings episode did not cause any systemic failure. The moral of the Barings story is that costs of abusing derivatives are highly concentrated. They are borne by those who violate laws (Nicholas Leeson) those who are derelict in their duties (managers of Barings), and those who fail to choose the right board of directors (shareholders of Barings).