Options and Futures have been a feature of trade since ancient times. Futures and options have been around as long as there has been commerce, because commerce involves risk. In the last two decades or so, such risks have grown almost exponentially, and these volatile trading conditions have created substantial growth in the use of futures and options. In the global integration; the use of Futures and Options products has changed the financial world.
Futures and Options are used to manage external business risks. It is therefore interesting to note that the phenomenal growth in their use coincided with the collapse of Bretton Woods fixed exchange rate regime and the suspension of the dollar’s convertibility into gold. Exchange rates suddenly became much more volatile and because interest rates affect and are effected by exchange rates, so interest rates also became much more volatile. A method of managing risk was required. This led to the creation and expansion of the Futures and Options in the financial markets.
It was soon after the collapse of the Bretton Woods Agreement and the ending of the fixed parity between the US dollar and the gold price in the early 1970’s, that the Chicago Mercantile Exchange introduced the world’s first successful exchange-traded currency futures. In 1975, the interest rate futures contracts followed, which allowed one to establish the future cost of lending and borrowing. By 1982, half-a-dozen exchanges had introduced various interest rate futures contracts, covering all from very short to longer-term borrowing.
The next step in the global use of such products for managing, controlling and speculating on risk was the introduction by the Philadelphia Stock Exchange in 1983 of currency options. Currency options linked the futures and options, which had arisen in the capital markets of countries having hard currency. Currency options and futures would lead to the development of many new risk management techniques. Without a tool for managing exchange rate movements, global trade and investment can be very risky. Without currency options and futures, many of the benefits that we enjoy today from globalization would not have been possible.
By the mid 1980’s, through the use of futures and options among other products, a revolution in financial, foreign exchange, and commodity risk management had taken place. On the Chicago exchanges, for example, the trading volumes involved tens of million of contracts annually. Options and futures exchanges were introduced in New York (New York Futures Exchanges) in 1980, in London (London International Financial Futures Exchange or LIFFE) in 1982, in Singapore Monetary Exchange (SIMEX) in 1983, while 1985 saw financial futures were introduced on France’s Matif. To meet the needs of the financial community for risk management, the development of new futures and options markets continued, with new contracts appearing regularly.
The phenomenal growth and use of futures and options has had many positive impacts which indicate that such instruments are extremely useful. These markets have not arisen in isolation but in response to the global integration of trade and finance. Arbitrage ensures that similar assets and similar risks are prices uniformly throughout the world, promoting stability. By being global in scope, futures and options markets have created a mechanism for pricing and transferring risk around the world. These markets have allowed institutional investors, banks, treasurers and corporate CEO’s to manage risks efficiently. Speculators without any underlying activity can take a view on virtually anything which is quoted on an exchange.
Today officials of corporations, banks and public entities cannot give excuses for not managing unexpected surges in interest expenses, swings in exchanges rates, or increased commodity prices affecting costs of their operations.
A salient feature in the growth in the use of Futures and Options has been the evolution and maturing of the Over-the-Counter (OTC) market. While traded futures and options are suitable for covering the risks of many corporations, often there are situations where only a tailor-made solution will satisfy specific commercial and financial objectives. Anew investment or an innovative financial structure may have an unusual risk/reward profile.
The “financial engineers” use off-the-shelf futures and options products to create unique risk/reward profiles. Termed ‘hybrids’, often they have been devised to address the combined risks involving several markets. It might be the ratio of gold to silver prices or an equity linked bond. To address these exposures, the financial strategist might use futures and options in combination, mixing for example, currencies and commodities and different maturities, all to achieve a particular objective.
The last fifteen years have certainly changed the economic landscape with regard to the use of futures and options as tools for risk management.