Emergence/History of Derivatives

The history of derivatives is so vast and is interesting to know that derivatives dated back to 16th century. Like forward delivery contracts, where the asset is to be delivered on specific date and time for an agreed fixed rate existed in the ancient Greek and Rome times, where the emperors of that time entered into these kind of contracts to overcome the foreseen problems, like falling short of grains required at the times of masses. Interestingly they worked out and thus gave a pavement to the new way of trading between farmers and merchants. Due to the uncertainty of prices and supply merchants started entering into the futures contracts with the farmers which was termed as “to-arrive” contract which allowed trader and farmer to trade with lock – in price. This made sense as it was safe for both the farmers and traders, from the farmer’s point of view it acted as insurance to them as the prices were uncertain all the time, like during the scarcity the prices went up and at the time of over supply he has to set off his asset at a very low price. Thus, this system benefited them with a peace in farming. From trader point of view, if the production is below the expected level there is a danger in buying quantity and even the prices may go up. Thus, price lock-in system benefited both the parties. Thus, it proves that forward contracts existed for centuries giving room to hedge the price risk.

There are many rumours that futures existed before 1650 but there is no concrete evidence of its existence. But, the futures contracts are generally traced back to rice market in Japan around 1650, and are evidently called as standardized contracts which looks like today’s futures contracts. But, there is no proper evidence weather they were marked with the market daily basis and weather there was credit worthiness. But, soon or later the official journey of derivatives was marked and initiated by U.S in 1848 with the creation of Chicago Board of Trade (CBOT) the main aim of CBOT was to deal with credit risk and provide a centralized location in dealing forward future contracts. Under CBOT from forward trading in commodities arrived the commodity futures. It was the first type of futures emerged and it was termed as “to-arrive”. In 1860 CBOT introduced the trading of commodities in futures. In 1865, CBOT first introduced the exchange traded futures contracts and it was the time derivatives came into limelight and started gaining impressive importance as it gives the opportunity to hedge the risk. In 1919 the rival exchange of CBOT was formed and it was named as Chicago Mercantile Exchange (CME) although it existed before under the name of Chicago Produce Exchange and Chicago Egg and Butter Board (CEBB). In 1925 the first clearing house was set in Chicago. International Monetary Market (IMM) was formed in 1972 and it was a division of CME, where the currency was traded in futures in this exchange. And it was for the first time futures concept was used on non-commodity. Only few and famous currencies like British Pound, Japanese Yen, Canadian Dollar, Australian Dollar and Euro Dollar were traded in IMM. Later on, the Interest Rate futures were introduced by CBOT in 1975. Soon, was followed by Stock Index Futures and Options which were first traded in the Kansas City Board of Trade (KCBT) in 1982. Soon, CME came up with successful futures contract called S&P 500 Index.

Options are also as old as Futures; even options can be traced back to Greek and Rome times. An option in the early stages was used to speculate the Tulips (famous flowers). During that period Tulips were on high demand and often the prices shot up and some times a sudden slump due to the high volatility people were even prone to mortgage their assets and business. In 1637, Dutch traders and farmers came together and entered in the tulip options to ease the volatility. But, due to lack of mechanism to guarantee the performance of Options; speculators on Tulips Craze options were wiped out due to sudden collapse in demand. In 1973 Chicago Board Options Exchange (CBOE) was formed, it was the first time after a long time they were back to trading with the help of revised Black – Scholes model, as this model mainly deals with the fair price of options. This model is also called as optional pricing theory which is said to be a revolution in the financial world where no one expected it. The trading in options bounced back with the help of this model. Options being back on the track CBOE stepped ahead and introduced options on index of stocks. Thus, CBOE 100 was formed and later it was termed as S&P 100 where the most actively traded 100 stocks were formed as index. As the options started gaining popularity American Stock Exchange (AMEX) and Philadelphia Stock Exchange (PSE) started trading in it since 1975.

After the Second World War, the world was urging for the economic reorder, during this period all the developed and less developed countries were under the Bretton Woods fixed exchange rate system and every one had to administer the prices and centrally allocate the resources. Soon, the Bretton Woods fixed exchange system under constant pressure from the early 1970’s. Inflations started hitting all time high and the rate of unemployment created high volatility in interest rates and it was the time to bid good bye to Bretton woods and that was the end of fixed exchange rate system in 1971 freeing the interest rates move freely by fluctuating. It created a positive repulsion to the less developed countries like India allowing them to open up their trading system, by allowing prices to change with the market conditions. As the floating exchange rate entered the financial world it became a hard task to business entities to predict the future price and was challenging to estimate the future production costs and revenues? Thus the derivative tools have become the important tool in hedging the risk giving them the opportunity to predict the future prices and cope with market uncertainties, which in turn helps in predicting the production costs maximising the profits.

In 1980’s it was the time for new innovations as derivative market started gaining popularity. As the man is always thirst of new innovations it led to introduce of swaps and over-the-counter (OTC) Derivatives, although OTC options and futures previously existed. Many large financial institutions and even some small investing companies started getting familiar with derivates and started using them effectively. Soon the no. of trades took place in options and contracts in CMOT exceed the no in daily trading of New York Stock Exchange Board (NYSE) from then there was no looking back. But, soon the Derivative world started hitting huge losses since 1994 and a series of companies started announcing huge losses due to the derivative trading like the Procter & Gamble, Mettallgesellschaft. Some companies even declared Bankruptcy. England’s fame Barrings Bank also declared due to speculative trading in derivatives. It was believed that most of the failure was not allegedly due to derivative trading, but accurately speaking it was due to the leverage options in the short term. All these issues started creating panic in the small investors, but soon most of the firm’s rules and regulations were tightened and continued to use derivatives.

In present days, derivative contracts exists for wide range of products like cotton, oil, precious metals, corn, sugar, etc. Unlike the previous derivatives are not confined to commodities and extended further into financial underlying stocks, namely securities, currency exchange rates, interest rates and etc.

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