3. History of derivatives market

Modern textbooks in financial economics often tend to misrepresent the history of the derivatives market. For instance, Hull (2006) puts forth that derivatives became significant only during the past 25years and that it is only now that they are traded on exchanges. Mishkin (2006) was more specific and he declared that derivatives are new financial instruments that were invented in the 1970s and that this was a result of an increase in the volatility in financial markets that created a demand for hedging instruments to be used by financial institutions to deal with risks.

The history of derivatives is in fact traced back to the origins of commerce in Mesopotamia in the fourth millennium BC. After the collapse of the Roman Empire, contracts for the future delivery of commodities continued to be used in the Byzantine Empire in the Eastern Mediterranean and they survived in canon law in Western Europe. During the Renaissance, financial markets became more sophisticated in Italy and the Low Countries. Contracts for the future delivery of securities were used on a large scale for the first time in Antwerp and then Amsterdam in the sixteenth century. Derivative trading on securities spread from Amsterdam to England and France at the end of the seventeenth century, and from France to Germany in the early nineteenth century.

The first exchange for trading derivatives happened to be the Royal Exchange in London, which permitted forward contracting. The first "futures" contracts are generally traced to the Yodoya rice market in Osaka, Japan around 1650. These were evidently standardized contracts, which made them much like today's futures, although it is not known if the contracts were marked to market daily and/or had credit guarantees. The next major event, and the most significant as far as the history of U. S. futures markets, was the creation of the Chicago Board of Trade in 1848. This came up when farmers faced difficulties to store the enormous increase in supply that occurred following the Midwestern grain harvest. Chicago spot prices rose and fell drastically. A group of grain traders then created the "to-arrive" contract, which allowed farmers to lock in the price and deliver the grain later. The grain was either stored on the farm or at a storage facility nearby, to be delivered to Chicago months later. These to-arrive contracts proved useful as a device for hedging and speculating on price changes. The grain could always be sold and delivered anywhere else at any time. These contracts were eventually standardized around 1865. Profit charts made derivatives accessible to young scientists, including Louis Bachelier and Vinzenz Bronzin, who had the mathematical knowledge for the rigorous analysis of derivative pricing. Consequently in 1925, the first futures clearinghouse was formed.

The Chicago Board of Trade (CBOT), the largest derivative exchange in the world, was founded in 1848 where forward contracts on various commodities were standardized around 1865. From then on, futures contracts have remained more or less in the same form, as we know them today. In 1919, the Chicago Butter and Egg Board, a spin-off of CBOT, was reorganized to allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME). In April 1973, the Chicago Board of Options Exchange was set up specifically for trading in options. The markets for options developed so fast that by early 1980s the number of shares underlying the option contract sold each day exceeded the daily volume of shares traded on the New York Stock Exchange. There has been no looking back ever since.

Thus while a few commodity-based (e.g., agricultural) industries have a long history of hedging with exchange-traded derivatives, the use of derivatives has indeed grown remarkably since the introduction of foreign exchange and interest rate products in the 1970s. Derivatives are not really new products; they were indeed around before the time of Christ however it is as from the 1970s that they started gaining popularity.

Today the size of derivatives markets is enormous, and by some measures it exceeds that for bank lending, securities and insurance. Mirroring this growth is an increasing volume of research that seeks to understand the economic rationales for financial risk management. For example, financial theory suggests that corporate risk management is bound to increase firm value in the presence of capital market imperfections such as bankruptcy costs, a convex tax schedule (Smith and Stulz, 1985), or underinvestment problems (Bessembinder, 1991; Froot, Scharfstein, and Stein, 1993).

Despite these developments, derivatives seem to remain a rather exotic area that often puzzles the public, who has come to know about these derivatives largely through the reporting in the news media of cases involving large losses. These cases include Enron (Partnoy 2002), Barings PLC (Kuprianov 1995), and Procter & Gamble (Miller 1997). One of America's wealthiest localities, Orange County, California, declared bankruptcy, allegedly due to derivatives trading, but more accurately, due to the use of leverage in a portfolio of short- term Treasury securities. England's venerable Barings Bank declared bankruptcy due to speculative trading in futures contracts by a 28- year old clerk in its Singapore office. These and other large losses led to a huge outcry, sometimes against the instruments and sometimes against the firms that sold them. There was presumably nothing wrong with the techniques themselves, just the way in which they were used. It is sometimes argued that measures to improve the safety of car occupants, e.g. seat belts, increase risk by encouraging drivers to go faster than they would without them. While some trivial changes occurred in the way in which derivatives were sold, most firms simply established tighter controls and continued to use derivatives.

It is possible that the sophisticated models that apparently enable risk to be accurately quantified encourage risk taking by financiers who would otherwise err on the side of caution. However that does not explain other scandals that have involved derivatives. Lots of economists warned about the dangers associated with derivatives and Sir Julian Hodge was one of the first to do so. The complexity of derivatives and the need for transparency in their reporting have led to several serious debates, the most recent being the collapse of AIG and the 2008 credit crisis in the UK.

Definition of derivatives

Derivatives are financial contracts on a pre-determined payoff structure, whose value derive from underlying assets, such as securities, commodities, market indices, interest rates, or foreign exchange rates. Derivatives have three main economic functions namely:

1. Risk management whereby the derivatives provide a mechanism through which investors, corporations, and countries can efficiently hedge themselves against financial risks. Hedging financial risks is similar to buying insurance; hedging provides insurance against the adverse effect of variables over which businesses or countries have no control. Managing of risk increases stability at all levels, risk diversification improves the fair market pricing, thus there is general welfare.

2. Price discovery which refers to the knowledge of prices. The ability of derivatives markets to provide information about market-clearing prices is an essential part of an efficient economic system. Futures and option exchanges widely distribute equilibrium prices that reflect demand and supply conditions. Knowledge of these prices is fundamental for investors, consumers, and producers to make informed decisions.

3. To provide transactional efficiency as derivatives lower the costs of transacting in financial markets. As a result, investments become more productive and lead to a higher rate of economic growth. Therefore, derivatives bring important social benefits and contribute positively to economic development. These benefits explain the massive growth in derivatives markets.

Derivatives are traded in two kinds of markets namely:

• Exchange Traded market, where derivatives are traded via an organized financial Markets/ intermediary. This category includes financial futures and options. These instruments have standard features like nominal size and maturity date. A derivatives exchange acts as an intermediary to all related transactions, and takes initial margin from both sides of the trade to act as a guarantee. The world's largest derivatives exchanges are the Korea Exchange, the Eurex and the CME Group.

• Over The Counter is a decentralized market of securities not listed on an exchange where market participants trade over the telephone, facsimile or electronic network instead of a physical trading floor. Trading occurs through a network of middlemen, called dealers who carry inventories of securities to facilitate the buy and sell orders of investors. There is no central exchange or meeting place for this market. Examples of instruments traded in an OTC market include swaps, forward rate arrangements and options. These contracts are normally 'tailor made', that is designed to meet the specific requirements of the traders. However their costs are higher than exchange traded instruments. Also, the absence of a clearing house for OTC contract means that there is an element of default risk and it is largely unregulated with respect to disclosure of information between the parties since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds. Anyhow the OTC derivative market is the largest market for derivatives