Financial Risk and Its Management Through Financial Derivative Products
Derivative Products and Their Trading in Organized Markets
A Brief History of Derivatives Markets
Derivative or forward product markets might seem modern, but they’ve always been intertwined with the evolution of trade.
In Aristotle’s Politics, there is mention of the philosopher Thales of Miletus enriching himself with one of these instruments by correctly predicting the olive harvest. Similarly, references indicate that these types of forward contracts were used during the Middle Ages between farmers and merchants. However, the first futures contract as we know it today was executed in Osaka in the 17th century. In Osaka, an organized market for rice existed, and these contracts provided liquidity to large landowners without requiring them to sell their assets.
The contracts were settled by differences (no physical delivery was allowed), but this caused significant distortions in price formation, leading the imperial government to ban the practice in 1869. It was reinstated some years later.
The first known book about the stock market is Confusion de Confusiones, written by a Spanish Jew, Joseph Penso de la Vega, who lived in Holland. His father fled to Antwerp after being imprisoned for a year by the Inquisition. In this 1688 book, one of the three characters, a shareholder, explains to a merchant and a philosopher what an "Opsie" is and describes a Call and Put option exactly as we understand them today.
To find the origins of today’s organized derivatives markets, however, we must look to Chicago. The Chicago Board of Trade (CBOT) was established in 1848, primarily trading agricultural products (rice, wheat, soybeans, etc.). Its purpose was to act as a bridge between farmers and merchants. Within a few years, they introduced the first forward contract known as "Contract to Arrive," which gained significant popularity.
In 1898, the CBOT created a subsidiary for trading processed agricultural products called the "Chicago Butter and Egg Board," which in 1919 was renamed the Chicago Mercantile Exchange (CME). By 1961, the CME had also started offering livestock contracts.
The CME was much less significant than the CBOT until the late 1960s when "Leo Melamed"—a lawyer born in 1932 to Polish immigrants fleeing World War II—became its chairman in 1969. Melamed innovated the market by introducing more sophisticated forward contracts, but the defining moment came in 1971 when President Nixon declared the U.S. dollar no longer convertible to gold, effectively ending the gold standard.
Melamed foresaw the resulting volatility in exchange rates and spearheaded the creation of currency futures. The cultural shift was immense, as CME traders accustomed to livestock contracts had little knowledge of currency trading. The product presentation included maps of countries and their respective currencies. These products were a significant success for the CME, challenging the dominance of the CBOT.
The CBOT quickly responded. Its president, Warren Lebeck, hired a young finance professor from Berkeley, California, named Richard L. Sandor. At just 22, Sandor designed a futures contract on mortgages called GNMA (Government National Mortgage Association) to cover the long end of the yield curve. After delivery issues, the underlying was changed to the 30-year U.S. Treasury bond, creating the Notional Bond Futures contract, which remains largely unchanged and highly successful to this day.
Both Leo Melamed and Richard L. Sandor are considered the fathers of modern financial derivatives.
In 1976, the CBOT established a subsidiary for trading stock options, the Chicago Board Options Exchange (CBOE). Thanks to Fischer Black and Myron Scholes, who developed a groundbreaking formula for valuing options in 1973 (later modified by Robert Merton), options trading finally became viable. Though initially met with skepticism, these products eventually gained widespread acceptance.
In Europe, derivatives markets did not emerge until 1978, when the Amsterdam Stock Exchange—the world’s oldest (founded in 1602)—established the European Options Exchange as a joint venture with the London Stock Exchange, later becoming fully Dutch-owned.
The early years were challenging, but the volatility of interest rates in the late 1970s and early 1980s significantly increased activity. Other European derivatives markets were established during the 1980s, such as LIFFE (London International Financial Futures Exchange) in 1982 and MATIF (Marché à Terme International de France) in 1986, promoted by the French Treasury.
In Spain, reforms to financial markets in 1988 allowed for the creation of derivatives markets: OM Ibérica in Madrid (1988) and MEFF in Barcelona (1989), which later merged into the MEFF Holding. In 2002, MEFF joined other Spanish trading systems to form Bolsas y Mercados Españoles (BME), which was acquired by the Swiss exchange group SIX in 2020.
The Rofex derivatives market in Argentina was created in 1909, initially focusing on commodities (such as wheat, soybeans, corn, etc.), and later incorporating financial derivatives in 2001. In Brazil, the BM&F market was established in 1986 after a series of mergers. In Mexico, MexDer was created in 1998, focusing on financial derivatives. In 2009, the Colombian Stock Exchange began trading financial derivatives. The MILA (Latin American Integrated Market) was established in 2011, integrating the stock exchanges of Colombia, Lima, Santiago de Chile, and later Mexico in 2014.
Asian derivatives markets had their beginnings in already well-established exchanges, particularly in Japan, such as the Osaka Exchange (1878) and the Tokyo Exchange (1878), which merged in 2013 to form the Japan Exchange Group. They began trading financial futures in 1988. The Hong Kong Futures Exchange was established in 1976 (initially called the Hong Kong Commodity Exchange) and began launching financial futures in 1986. In 2012, it acquired the London Metal Exchange (LME), a derivatives market for metals. Korea Stock Exchange, founded in 1956, began trading index futures in 1996. In Taiwan, TAIFEX was established in 1998 and has been trading financial derivatives since its inception.
Other Asian markets emerged during the 1990s and early 2000s, primarily focusing on commodities derivatives, such as China's Dalian Commodity Exchange (1993), Zhengzhou Commodity Exchange (1990), and Shanghai Futures Exchange (1999). In India, a series of derivatives markets also emerged: the National Stock Exchange (1992), based in Mumbai, launched its first financial derivatives in 2000. The Multi Commodity Exchange (2003) and the National Commodity and Derivatives Exchange (2003) are two major Indian commodities derivatives markets.
Today, Asian derivatives markets constitute a significant portion of global trading volumes.
Organized vs. non-organized markets
Trading in financial markets involves making decisions without certainty about how asset prices will evolve in the future, which means assuming what is known as price or market risk. Forward operations or derivative products are an important tool for managing this risk, as they allow the price at which an economic transaction will take place in the future to be fixed today.
This practice has been widely used for centuries, when farmers and merchants, interested in guaranteeing the price at which they could sell or buy a particular crop, would agree in advance on the terms of the exchange.
However, to execute a forward operation, it is necessary to find another economic agent with opposing interests who is also willing to act as the counterparty in the transaction. For instance, a company seeking to secure an investment interest rate six months in advance must find another agent that needs financing in six months and wishes to lock in the interest rate.
In a complex economic system, finding a counterparty is not particularly easy. On the contrary, it generally entails significant search and negotiation costs, which can outweigh the advantages of risk elimination or hedging. Additionally, the company initiating the search for a counterparty cannot be certain that the price it ultimately pays is the best available. Lastly, there is always the possibility that one of the contracting parties will fail to meet its obligations, resulting in severe economic harm to the other party.
Thus, economic agents not only need to find counterparties whose positions are symmetrical to theirs, but they also need to ensure that these counterparties are solvent enough to guarantee the fulfillment of the agreement. This requires conducting a credit analysis of potential counterparties, adding further costs to direct forward negotiations.
In summary, while direct forward trading is, in theory, an effective instrument for eliminating market risk, in practice, it can be very costly and may not justify the benefits it offers. These costs stem from the difficulty of finding a counterparty, the high negotiation costs, and the potential risk of insolvency.
The type of trading described so far is referred to as OTC (Over The Counter)—literally translated as "over the counter"—because it is tailored to the needs of a specific investor. Similarly, OTC or non-organized markets refer to the place (not necessarily physical) or framework in which these operations are conducted.
To address the drawbacks of direct trading, forward operations in the context of organized markets were introduced. Their main feature is the existence of a central clearing house that intervenes in every economic transaction, acting as an intermediary between the buyer and the seller. This way, there is no direct relationship between the two parties; instead, they acquire a set of rights and obligations with respect to the clearing house, which ensures the fulfillment of all transactions (if one party defaults, the clearing house assumes the obligations).
Furthermore, this new framework provides a standardized system for trading and registering operations. This standardization applies to the various available assets and their trading conditions, as well as the expiration dates of operations. As a result, since all agents are trading with the same contract, the potential number of buyers and sellers increases significantly, facilitating the process of finding a counterparty (reducing liquidity risk).
Thus, investors in an organized market must adapt their operations to the existing standardized contracts. In return, they benefit from significantly lower costs for finding counterparties and eliminate default or insolvency risk.