Operational Advantages and Market Functions of Derivatives

No, that's not true unfortunately. You still have to have capital up front for derivative trading, although not as much as with trading the actual underlying security. As an important note, some forms of derivative trading (for example, selling options) actually generate capital up front. However, there is a risk on the back end that may require the capital to be reimbursed. Thus, there is almost always a need for up-front capital in derivative trading.

Derivatives have numerous __operational advantages__ over the underlying asset on which they are based. Consider a stock option contract. Typically, one option contract has 100 shares as the underlying and the cost to purchase the option contract is a fraction of the share price. In futures contracts no money changes hands at inception; so, the investor can gain exposure to the underlying asset without paying any money up front. What does this mean to the investor who uses derivatives to speculate on future asset prices?

No, that's not true unfortunately. You still have to pay transaction fees, but they are typically not as financially burdensome as actually buying and selling the securities.

Incorrect. Derivatives allow a highly levered position that is typically significantly riskier than investing spot in the underlying asset.

Correct. By using derivatives, investors are able to realize highly leveraged positions that would typically be more difficult to establish in spot markets.

In derivative markets it is typically equally easy to purchase a put or call option. Why do you think this feature is so important to investors?

Correct. It is often difficult or costly to enter a short position in the spot market which would allow the investor to benefit from negative information regarding the value of the underlying. Buying a put allows an investor to speculate on a decrease in asset value.

Incorrect. While this is true, it is not particularly valuable to investors. It is easy to enter a long position in spot markets as long as you are willing to pay the going price for the asset. It is often difficult or costly to enter a short position in the spot market that would allow an investor to speculate on negative information.

For example, imagine you had information that a private company was going to shortly introduce a new product that would make an existing product obsolete. Because the innovative company is private it is not possible for you to buy shares in the company, so you decide to short sell shares in its competitors instead. __Short selling__ involves finding someone to borrow the shares from. It incurs high transaction costs and you bear the risk that the person who lent you the shares will recall the loan at any time. A put option gives you a similar exposure with lower transaction costs, no recall risk, and can be purchased on an exchange.

There's also risk management to consider. The creation of derivative assets would allow you to do one _very_ important thing that selling the asset would not. What do you think that could be?

The highly leveraged nature of derivative markets has two spin-off benefits. First, transaction costs are typically lower in the derivative market relative to the cost to replicate the same exposure in the spot market. Second, because of the low cost to purchase derivative contracts, derivative markets are typically more liquid than spot markets.

That is correct! The huge advantage of derivative trading is that you can manage the risk of an underlying asset without actually trading the asset itself. Thus, you can still retain the advantages of ownership while minimizing risk exposure.

Derivatives also allow for __price discovery__ by allowing you to view the expected future spot price. The futures markets open before the stock markets, and the futures price on the S&P is exactly what it sounds like, a way to trade the S&P at a point before the actual value is known. How closely do you think futures markets predict future prices?

No, the price forecasts in futures contracts are typically pretty accurate as the futures markets are generally very efficient. However, there is no reason to believe it will be perfectly predictive.

Yes, that is correct. The futures markets are very efficient, so predictions are likely reasonably accurate. However, futures markets aren't perfectly predictive.

Finally, an __efficient market__ is one in which asset prices reflect all available information. This means that no one can earn a return in excess of what would be fair considering the risk of the investment. If a market is efficient, do you think this means that prices are always "correct" in the sense that prices reflect asset fundamental values?

Incorrect. Market efficiency simply suggests that the return you earn is commensurate with the risk you take. Prices may depart from fundamentals, even for a significant period of time. This does not mean markets are inefficient.

Correct. In an efficient market, price may depart from fundamental values, but there is not a clear way to benefit from mispricing.

Based on these characteristics of derivative markets, do you think price discovery for stocks occurs more frequently on the New York Stock Exchange (NYSE) or the Chicago Board Option Exchange (CBOE)?

No, informed traders are going to favor the market with the lowest transaction costs, where a position can be entered at the lowest costs, and where liquidity is higher. This means investors will favor derivative exchanges over stock exchanges. Prices on derivative exchanges often lead prices on equity and bond exchanges, reflecting that is the dominant location of price discovery.

Correct. Traders with information are most likely to trade on the exchange which has the lowest transaction costs and allows them to enter speculative positions at the lowest costs. Prices on derivative exchanges often lead prices on equity and bond exchanges, reflecting that is the dominant location of price discovery.

Additionally, derivative exchanges are often more liquid than stock markets, creating further incentives for investors to favor option exchanges.

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Another important part of information discovery is __implied volatility__. Many derivatives like options are more valuable when the underlying is volatile. The ability to look at derivatives prices along with "what if there was no volatility" assumed values allows traders to see how much volatility the market is assigning to each underlying.

Derivatives are lower risk because less of the investor's money is used

Derivatives allow a highly levered position

It makes it easy for investors to speculate based on negative information

It makes it easy to replicate a long position in the underlying

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Derivatives allow you to minimize risk without transaction costs

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Derivatives allow you to manage risk without using capital

Derivatives allow you to manage risk without actually trading the underlying asset

Predictions are not very close

Predictions are quite accurate

Yes, prices always reflect fundamental values

No, prices may not always reflect fundamental values

On the NYSE

On the CBOE

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