Value of Derivatives

While at the Credit Suisse Global Trading Forum 2013 in Miami during the last week of February, I noticed an interesting indirect exchange between the former Governor of Vermont Howard Dean and Professor Stephen Ross (who coauthored the binomial option valuation method).  While slashing at the easy targets like "flash trade", "dark pool", and Wall Street in general, Dean claimed that only 15% of derivative volume is useful.  In the session followed, Professor Ross got on the podium and immediately retorted that 15% statement, instead, he stated that majority of the option volume is useful.  Actually with the predictive view expressed in the option market (which was the topic of his speech), he said, the equity option market should be 5 times larger.

As an active participant of the option market, I am obviously biased and tend to agree with Prof Ross.  While on the topic, it is worthwhile to look at the social function, or "usefulness", of derivatives. There are 3 integrated functions in a financial market: investing, price discovery, and providing liquidity.  The first function – “investing”- can be easily understood, while the other two functions seem to be a bit more esoteric.  Ultimately, this comes to the question of how the price of an asset gets determined.  It is through a price discovery mechanism, and realized through a trading process with a liquidity provider and a liquidity taker. 

Ideally, a market is a place where suppliers meet buyers. However, typically "intrinsic" buyers and sellers may not be able to meet in the same space/time (for example, the crops produced by a farmer are typically not consumed locally and at the same time).  Thus market provides a continuous value chain that connects between these 2 end users.  The value chain is created by a community of investors, market makers, and speculators, collectively called traders.  The market serves as the center where various views of the asset prices are competing and evolving.  Uncertainties in the pricing arise due to the unlimited number of unknowns, and a natural generator of uncertainty, which is called "time".  A trade occurs when there is a natural buyer and a natural seller meet at the same price level. The natural side or the initiating side of a trade can be buying or selling, and may have various motives to initiate the trade. Thus the price of the transaction is determined at the moment by the opposing side at a level the he is willing to take the opposite side of the trade.  Thus we look at the market where trades happen and prices are set: we have a chaotic pool full of uncertainties: in prices, in time, in side of the demands (buy or sell), in future yields and interest rate, etc.  Prices are thus determined by a discovery process that seems to contain many unknowns, and realized through the meeting of the bid and ask prices, the so-called liquidity providing process. Prices may look random, but price at every trade is “correct”, in the sense that the buy and the sell side transact at exactly the same price.  The uncertainty or randomness associated with a free market is intrinsic to the price discovery and liquidity providing mechanism, rather than a defect of the market.

But wait – Aren’t the factors of uncertainty in the side of demand in prices, time and carry cost (interest/dividends etc.) all that is needed to determine the price of option? 

Options make a perfect product that captures the pricing mechanism of market and quantify the uncertainties in various dimensions.  The uncertainty of initiating demand in buy or sell side is represented by the call and put (even though put only came into existence in 1977); the uncertainty in price is described by volatility.  The uncertainty in time is captured by the availability of various expiries of option products. Without options, the randomness of price movement caused by the instant supply/demand or different views is just a fact of life and cannot be controlled or measured.  Derivatives turn such pure randomness and uncertainties into something that can be managed by marketable products, and become an important part in chain of the price discovery and liquidity providing.

Let’s come back to the example of a crop farmer to see how a financial market becomes a tool of investment and connecting the supply/demand.  Before he plants the seeds, the farmer can sell the futures contracts of his crop and use the proceeds as part of his investment.  On the other end, a consumer of the crop can purchase futures on a term that fit into his needs thus lock in his cost in his production chain (but may not match the production time on the farmer side). In between, the market would work its magic to connect the dots.  Through continuous supply/demand, speculations, analysis, and views on various conditions from weather to macro economy, the market creates a random but continuous path of prices.  Using options, the randomness in prices and the uncertainty in time can be quantified and priced, a value can be put on the volatility and time, and risk can be taken, managed or transferred.

The usefulness of derivatives comes in the same place as the function of a free market -- A free market has no authority to tell you what a price should be.  Price is "discovered", liquidity is “provided” with a cost, speculation is a natural incentive for participants to provide a continuous bid/ask price stream for both side of the market.  The fact that most assets on a public traded exchanges today have a readily available bid/ask prices is a strong testament to the success of the free market; and the fact of a continuing shrinking of the bid/ask spreads across all asset class in recent decades is a proof of the efficiency of such market.   Options are an integral part of the free market; it puts a tradable value on the seemingly random process of the market.

Now let's look at Prof. Ross's "5-time" statement.  A 5-time increase in equity option volume?  Probably an overstatement, but I'm certain that 90% of current derivative volume is useful, albeit its function is likely to continue to be misunderstood by the public outside the financial community.