FINANCIAL DERIVATIVES are instruments whose value is derived from one or more underlying financial asset. The underlying instrument could be a financial security, a securities index, or some combination of securities, indexes, and commodities.
HISTORY AND EVOLUTION OF DERIVATIVES
The evolution of financial derivatives during the past two decades is related to the fundamental changes that have occurred in the financial markets. Innovations in financial theory and increased computerization, along with changes in the foreign exchange markets, the credit markets and the capital markets over this period, have contributed to the growth of financial derivatives.
The first exchange-traded financial derivatives emerged in response to the collapse of the Bretton Woods system of exchange rates established in 1944. Under this system, most governments agreed to fix the exchange rate of their currencies relative to the U.S. dollar, which was convertible into gold. In 1971, the U.S. Treasury abandoned the gold standard for the dollar, causing the breakdown of the fixed-exchange system, which was replaced by a floating-rate exchange system. The need to hedge against adverse exchange-rate movements provided an impetus for currency futures to emerge. Foreign currency futures were introduced in 1972 at the Chicago Mercantile Exchange ("Mere"). In 1973, the Chicago Board of Trade (CBOT) created the Chicago Board Options Exchange (CBOE) to facilitated the trade of options on selected stocks.
Futures conttracts on interest-bearing government securities were introduced in mid-1970s. In October 1979, the Federal Reserve Board decided to abandon its earlier policy of setting interest rate targets and replaced it with money supply targets. The shift in Federal Reserve policy increased the interest-rate volatility of Treasury bonds (Remolona, 1993). The resulting increase in volatility invigorated the demand for derivatives to hedge against adverse interest-rate movements.
The advancements in options pricing research along with improvements in computer technology laid the groundwork for new portfolio management techniques. These portfolio management techniques required a futures proxy for equities that could be sold to hedge against a downswing in stock prices. The Merc and the CBOE responded to the needs of portfolio managers by introducing futures contracts on equity indexes in the early 1980s.
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