The development of derivatives markets influences financial markets and economic growth. It redistributes risk from risk-averse people to those more risk-seeking, making it possible for individuals and companies to take on riskier projects with higher promised returns.
However, it must be made clear that these benefits outweigh the risks.
Many financial institutions use derivatives to reduce the risks of their investments. Individuals saving for retirement may invest in a mutual fund or exchange-traded fund that is hedged against the day-to-day fluctuations of the underlying stock or bond market.
How to practice derivatives? For a business seeking to manage its financing costs, derivatives can be used to hedge against future interest rate rises or decreases. This hedging can help to ensure that a company’s cash flow is not adversely affected by changes in the financial markets.
Derivative instruments can also be used to redistribute risk between different investors. For instance, the standardized trading of options on a stock exchange requires the parties at risk to deposit money with the exchange in case they lose money, and banks that help businesses swap variables for fixed interest rates on loans can do credit checks before granting access. This helps limit one party’s exposure to another, which can be an important consideration for some businesses.
Other forms of hedging can involve financial derivatives, such as forward rate agreements or FRAs. These derivatives can also be illiquid, and valuations are more complex. These illiquidities may contribute to less transparency and reliability in accounting statements, as the values placed on such instruments are often based on subjective management decisions rather than public market prices. This can lead to a wide range of values for similar derivatives in the same company or between companies with identical assets.
There is little doubt that speculation is a key force in the financial markets. After all, it is easy to attribute every financial crisis since the tulip mania of the 1630s to some form of mass speculation. Speculation involves purchasing and selling assets when their price falls to make a profit. It can also take the form of investing in new or emerging technologies, as with venture capital firms betting their investments will be profitable.
Speculation is a valuable economic service because it allows people to hedge against risk. The speculator’s loss is the hedger’s gain, so the hedging market helps reduce volatility and encourages investment. Moreover, trading derivatives with an uncapped risk level allows investors to invest in risky assets without accumulating liquid capital.
In addition, developing a derivatives market helps increase information flows in a country’s capital markets and thus reduces price volatility. As a result, it is widely believed that derivatives can stimulate investment in emerging and developing countries by reducing the disincentives caused by interest rate volatility.
However, the benefits of a derivatives market are thought to diminish as its size grows (and the relationship between derivatives market development and economic growth becomes less clear). This makes it important to maintain a robust regulatory framework that protects the interests of individual traders and investors.
In the financial market, derivatives promise payoffs not based on ownership of a particular asset but on the value of an underlying instrument (such as a stock, bond, commodity, or even the temperature at Kennedy Airport). This makes them attractive to individuals and institutions wishing to move risk around without owning the underlying asset. For this reason, the size of the derivatives market correlates positively with economic growth in developed countries.
Derivatives can also be used to speculate, gaining the right but not the obligation to buy an asset when its price is low or to sell an asset when its price is high. Some individuals and institutions assume the risks of speculating rather than hedging against them, leading to earnings and cash flow volatility.
In addition, speculators expose themselves to counterparty risk, which varies depending on the type of derivative. For example, standardized stock options are legally required to require the party at risk to have sufficient money on deposit; banks that help businesses swap variable for fixed rates on loans do credit checks.
Valuation is a challenge for derivatives because they are usually leveraged instruments, meaning that their potential risk and reward increase with the size of the contract. In addition, many derivatives are traded in illiquid markets, making it difficult for traders to agree on their value.
A central issue with financial derivatives is their proper valuation. They do not have a fixed, liquid market price for their underlying asset. Instead, their pricing depends on the assumptions used in modeling the risk. Thus, it can be difficult to determine whether a given derivative is hedging or speculative. This is especially true for OTC derivatives that are not traded on exchanges and are thus not observable.
One way of valuing an OTC derivative is to examine its ability to offset the risk of its underlying asset. For example, a trader who wants to hedge against the negative impact of an economic data release can buy an underlying asset and then sell another derivative contract with characteristics that countervail its own risk. This is equivalent to offsetting the first derivative’s risk with a new contract and is therefore considered a strong demonstration of its value.
The development of financial derivatives markets has long been a subject of interest among economists and other researchers. However, empirical investigations on the nexus between derivatives and economic growth have been hampered by the need for more reliable pricing data on these instruments.
This paper seeks to overcome this limitation by using a statistical technique that estimates robust empirical relationships between derivatives and economic growth based on cross-sectional and panel data for both developed and emerging markets.