The Economics of Derivatives

As was seen in Chapter 1, derivatives volumes have expanded stupendously over the last three decades. This chapter provides a broad historical perspective on the reasons for this expansion in the period preceding the global financial crisis of 2008.

Structural changes in financial markets

The period from the late 1960s to the early 1980s witnessed major structural change in world financial markets. It witnessed the rise of the ‘eurodollar’ market where non-American institutions raised and deposited dollars in Europe and elsewhere. The fixed exchange rate regime that prevailed from 1945 fell apart and most major currencies began to float, creating currency risks that had been absent earlier. In the late 1970s and early 1980s, influenced by ‘monetarist’ economists like Milton Friedman, several leading central banks (the US and UK for instance) began to target money supply as a means of controlling inflation, using interest rate changes as the main instrument. They thus moved from relatively stable interest rates to frequently changing rates, greatly increasing interest rate volatility.

The Arab–Israeli war and oil embargo of 1973 and the two major oil crises of 1973 and 1979 greatly increased uncertainties in the commodity markets. They also resulted in huge foreign exchange surpluses with major oil producing countries (‘petrodollars’) which had to find investment avenues in the international markets.

Together, these changes resulted in a quantum leap in the level of uncertainty faced in the financial markets and hence the demand for instruments of risk management such as forwards, futures and options.

While floating exchange and interest rates, commodity price volatility and uncertainties were proximate causes for the growth and use of derivatives, other forces were also at work.