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.
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 index-based 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 academic assessment of the very existence of index-based derivatives and the implications of the still-growing popularity of these complex risk mitigation, arbitrage and speculation instruments are both in short supply.
Analysis And Interpretation
In comparison, the World Federation of Exchanges calculates the global market capitalization of all equity markets at just under $47.5 trillion (World Federation of Exchanges 2012). Despite the upward trend in global equity market capitalization (see Figure 5), this number is dwarfed by the dollars traded in derivatives on exchanges, let alone OTC. Certainly, the attractiveness and widespread use of index-based derivatives is ubiquitous across markets. Moreover, as displayed in Figures 2-4, the growth of both OTC and exchange-traded derivatives, which include an abundance of index-based vehicles, has been more than significant in recent years. The towering derivatives market is a commentary on our mindset as investors and on our constant need to manipulate the market portfolio in our favor. Achieving more upside and less downside is our historic struggle, and the outsized derivatives market is evidence of the lengths we will go to in our quest for alpha.
The introduction of index-based derivatives is seen by many as the most important financial market advancement in modern times. Banks, pension funds, insurance companies, mutual funds, exchange-traded funds, separately managed accounts, hedge funds and government holdings all partly consist of index-based derivatives. Their presence has become common practice to most institutional investors and even many retail investors. “In fact, index-based contracts have become such an indispensable feature of the global financial system that it would be safe to say that there are many millions in the West who own, either directly or indirectly (even unknowingly), index-based derivatives,” (Millo 2007).
Since the invention of the stock index as a concept in the 1890s by Charles Dow, investors have worked to continually obtain relative outperformance against a comparative benchmark. In doing so, market participants have increasingly sought to capitalize on any opportunity to increase yield and/or decrease risk. Anything offering the prospect of outsmarting markets is afforded a chance. And preference is given to those securities and investment vehicles that possess certain fundamental attributes, key among them liquidity, low transaction costs, low capital requirements, transparency, and flexibility in design. Index-based derivatives made for an almost perfect match, offering participants the occasion to once again endeavor to outmaneuver markets and defy a fundamental law of finance—the relationship between risk and return.
Modern portfolio theory and the efficient frontier, as initially presented in the Journal of Finance by Harry Markowitz in his seminal 1952 work “Portfolio Selection” and built upon throughout the second half of the 20th century, is the foundation for proper portfolio construction and management. Within it, an important correlation exists between risk and return (the risk/return continuum). Risk is directly linked with return, and return directly linked with risk. The more return one desires, the more risk one must take. And conversely, the less risk one desires, the less return one can make. Market participants all too often, whether consciously or not, try to overcome the continuum. As such, portfolios rid themselves of surface risk—those risks that are easily identifiable and diversifiable—but carve a deeper hole insofar as human risk is concerned. Human risk—the blindness of participants thinking markets can be outwitted and certain laws of finance evaded—is omnipresent, and if unchecked, leaves portfolios and the global financial system open to great loss. Human risk takes place at the hands of investing ignorance and finds sustenance in a general lack of humility of participants relative to the randomness and aptitude of the markets themselves. The main reason for the rapid rise in popularity of index-based derivatives is their seamless fit for mitigating surface risk—perfectly satisfying participants’ appetite for peace of mind, while letting far more serious risks go unnoticed. Unfortunately—and potentially very grave for markets and the global financial system—the implementation of index-based derivatives not only conceals human risk but exacerbates it. Derivatives—more specifically, index-based derivatives—owe their popularity to their ability to exaggerate human irrationality. Index-based derivatives take human risk—the same risk that makes it so difficult for participants to buy low and sell high, so difficult for participants to simply own the market portfolio—and conceal it deeper between assets of even the best investment platforms.