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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).