Introduction
In the financial context, derivative refers to a contract between a buyer and a seller, which takes place today and regards a transaction that will be fulfilled at a future date (Ross, Westerfield & Jordan, 2002). It is a contract stating the conditions, consequential values of the concerned variables, dates, and amounts under which payments are to be made between the concerned entities. In this context, it is a contract signed in the financial markets for derivatives (Citi Bank, 2012). This paper describes the absolute global size, growth, and reasons for volatility in the derivative market. Derivatives traded can be divided into two vital categories. This includes exchange-traded derivatives and derivatives traded over-the-counter (OTC).
Nonetheless, derivatives are different from securities. They are mainly used for protection and management of risks and are for investment purposes. They provide varying types of protection from risk and enable modern and innovative methods for investing. Usually, derivatives markets operate under a regulatory regime to ensure efficient operations, safety, and innovations. Derivatives are used to trade future risks. They do this by eliminating uncertainties in the market through exchange of market risks, normally referred as hedging (Ross, Westerfield & Jordan, 2002). Derivatives are also used as intangible investments. They are an alternative to direct investments, assets, and properties. It is also used by investors who wish to have total transaction costs that are low compared to direct investments. Finally, derivatives are used when there is need for fast innovation of products. Contracts can be engaged and structured faster to meet specific market requirements.
The Size of the Derivatives Markets
Derivatives markets are large and have grown faster in the last 20 years. According to the international swaps and derivatives association (ISDA), the international value of all derivative transactions worldwide was 587 trillion dollars in 2007 (ISDA, 2009). This is larger than the combined GDP for the entire world in 2008, which was only USD 60 trillion. The derivative market is so large that it has an influence in the entire world’s financial structure. The influence of the derivative market on the world’s financial system was felt in 2008 during the global financial crises. Transactions in the derivative markets are mostly for speculation instead of hedging. Liquidity in the market is usually from speculators, who in doing so, transfer risks.
In order to know the size of the market, the value of credit that swapped in 2007 is comparable to the value of household real estate in the same year. The total default credit swaps in 2007 were USD 62.2 trillion while worldwide household real estate total was a mere USD 19.9 trillion (ISDA, 2009). Over-the-Counter segment of the derivatives market usually operates without considering national boundaries and thus is accessible to customers globally, meaning that the market is very large. The participants in the market are usually able to connect and trade distantly and with ease as long as there are no market restrictions that are likely to create trading barriers. The derivatives market is truly worldwide and enormous when taken as a whole. Today, for example, a major derivatives exchange known as Eurex generates 80% of its turnover outside its domestic markets (Germany and Switzerland) while a decade ago it managed only 18%. This is a considerable provision in the context finance (OECD, 2007). It helps in understanding various provisions of derivative markets and other related market provisions.
It is important to agree that derivatives market can be dangerous to major and minor economies should there be a problem in its operations. For example, it is the greatest threat to the US economy. It dwarfs mortgage disasters and high prices in petroleum products and food. Recently, the whole financial structure of the entire world is based on derivatives (Ilyina, Mathieson, Ramaswamy & Roldos, 2004). Thus, proper management of derivative markets is vital. It affects the entire world in the economical realms. This is a considerable provision when considered critically. It is crucial to understand the growth and other provisional aspects of derivative markets. Relevant actions such as speculation in the context of derivative markets have the ability to affect the whole world in different ways. These actions have the ability to create emergency situations like food or oil crisis in a very short time.
Speculation in the product futures markets due to fall of derivatives’ financial markets, for example, can lead to food shortages. This is because traders are likely to withdraw a lot of money from mortgages and equities and put the money in food and raw materials. This has the effect of raising food prices and the result is starvation. The size of the derivatives markets can also be shown to be enormous when the players in the markets are considered and the profits or losses that they make are studied. The major players in these markets are extremely large banks and insurance industries among other financial institutions. The size of their participation in the derivative markets often raises worries of huge losses that are likely to cripple the financial structures of a country.
Growth of the Derivatives Markets
The benefits of derivatives like transfer of risks and risk alleviation have led to the rapid growth of markets in recent years. These benefits have become more and more important making most investors and speculators to prefer getting involved into these contracts. In Europe, derivatives are very significant forming an integral part in the financial service sector of Europe. It is also a major contributor to Europe’s economic growth. Around two decades ago, the market for derivatives was small. It started growing at a rate of 24% yearly in the last decade. Currently, the market is large and is global with a notional outstanding amount of about 457 trillion Euros.
The OTC segment accounted for around 84%of the derivatives market even though the exchange segment has grown at a rate faster than the over the counter segment in recent years (BIS, 2002). The faster growth of the exchange segment in recent years is most likely a result of the standardization of the contracts that facilitate exchange trades. The other reasons contributing to faster growth of on-exchange trade are transparency in pricing, risk alleviation and low transactional costs. The derivatives markets have also grown faster due to innovations that have taken place in the recent years. Innovations in product and technology in addition to competition have led to growth that have resulted in job creation in the derivatives markets and other sectors that relate with it.
Concurrently, derivative markets have a globalized nature and the people who use it can trade during any time of the day and are exposed to all markets and assets. Similarly, this reason has led to the rapid growth of the derivatives markets. It is a professional market for wholesalers such as investment banks and insurance companies and has two segments competing. Derivatives markets have also managed to grow successfully due to effective regulation (Ross, Westerfield & Jordan, 2002). The markets are always well-functioning with safety and efficiency being always taken into consideration. Additionally, innovations that ensure improvement in the operations of the market are always adopted leading to further growth of the markets. This is crucial provision when considered in the financial context. It is important to establish such provisions in various contexts.
Structural changes in the way Over-the-Counter (OTC) and exchanges operate are not necessary; nonetheless, any improvements that leads to further efficiency in the operations are always welcome as they lead to more growth of the markets. For example, improvements that lead to more transparency in the market and helps in the mitigation of risk in the over-the-counter segment are likely to increase efficiency and attract more players leading to more growth of the markets. Efficiency and constant improvement in the markets assists the markets to achieve the functions of efficiency in prices and risk mitigation. Concurrently, derivative markets are well functioning. They are risk alleviation mechanisms that are effective, efficient, and affordable. Additionally, they are functional and applicable in various contexts. It is crucial to adopt innovations that lead to their improvements. This is possible through a regulatory framework that is highly beneficial. Derivative market is very large and has experienced phenomenal growth over the last two decades. Over-The-Counter segments of derivative markets usually operate without considering national boundaries (IMF, 2010). In other circumstances, participants in the concerned market can connect and trade distantly.
Reasons for Volatility in the Derivatives Markets
High volatility in the derivatives market has always been taken to create more trading activities. Studies have also shown a positive relationship to exist between volatility and the extent of activity in the derivatives markets (Gatheral, 2011). These studies mainly found that there is a positive association existing amongst fluctuations in the prices of equities, future markets, and the volume of trade. Therefore, the studies have shown that one of the reasons for volatility in the derivatives markets is the volume of trade. One of the factors that could account for such a positive relationship is uncertainty. Uncertainty is likely to lead to increase in hedging and speculative trades in the market. Risk-averse traders, when faced with uncertainty, are likely to be induced to move risk to traders who are risk takers or who are able to contain the risk. Uncertainty also brings about a more speculative reason to enter a trade as it is associated with asymmetry in information. This is a critical consideration in varying contexts with respect to derivative markets.
Hedging is another reason for the mentioned volatility in the derivatives market. Traders who practice hedging usually use mechanical strategies in fixing their preferred time period for the portfolios with fixed income. Therefore, this means that any price changes expose them to certain risks automatically. To avoid risks, traders have to change their exposure to risk by choosing a suitable hedging option like either dynamic hedging or immunization. In dynamic hedging, traders buy or sell the concerned assets to retain a proportionate exposure to the option. Concurrently, it immunizes financial institutions targeting the gap in period of their liabilities and assets (Gatheral, 2011). This is a crucial provision when considered critically in the economical contexts. An increase in the interest rates usually make the period shorter forcing the traders to take a decision to invest in longer term assets so as to enable them return to their target duration. These explain that changes in price are usually accompanied by trades in the concerned assets and bring about volatility in the volume of trade.
The other cause for volatility in the derivatives markets is speculation. Usually, speculations are based on information regarding the concerned economy. Public or private information in the market is likely to cause volatility. It has to be specific on the concerned market. New private information in the market is usually reflected in the fluctuations of the returns and the volumes traded of a single equity. Individual stock prices are usually influenced by the company’s specific information rather than information for the whole economy. The firm’s specific information is usually private and is delivered to the market through trades. The delivery of such information in the market has the effect of generating volatility in prices and volume of trade in the derivatives markets (Gatheral, 2011). Public information on the other hand is usually available for the entire market and is usually delivered through macro-economic statistics releases by the government. The entrance of public information in the market is usually linked to a sense of disagreement. Usually, this increases trade hence contributing to the mentioned volatility.
Conclusion
Derivative markets are extremely vibrant, have grown tremendously in the past 20 years, and form a critical component of the world’s financial system. In the derivatives markets, business competition between the on-exchange and over-the-counter (OTC) providers has enabled faster growth of the markets through continuous innovation in technology and product development. This, together with structures that ensure efficiency and safety in the market, has ensured that derivatives markets function efficiently and improve constantly. Contextually, concerned markets have grown rapidly due to the benefits of derivatives such as transfer of risks and risk alleviation. They have also grown as a result of innovations, which have recently taken place in product and technology in addition to increased competition. These have increased efficiency in the markets coupled with affordability in prices and mitigation of risks. Additionally, derivative markets have grown faster due to transparency in prices, risk alleviation, low transactional costs, and its global nature. Finally, it has grown rapidly due to effective regulation, which ensures that the concerned markets are well functioning. This is a critical provision when considered critically. Derivative markets are usually very volatile as evident in the nature and volume of trade as well as the prices. There is a positive association between fluctuations in prices and the volume of trade in these markets. Usually, hedging and speculative activities in these markets lead to increased activities in the markets resulting into volatility in the market. Additionally, uncertainty in the market pushes traders into hedging while speculation in this context is associated with the entrance of new information into the market.
References
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