Derivative

A derivative is a set of financial instruments that includes futures, forwards, options, warrants, and swaps. A derivative is a financial product that could, conceivably, take any form whatsoever. There are only two constraints on the creation of such products: the willingness of market-makers to innovate in areas outside their technical expertise, and the willingness of market participants to be persuaded that new products offer greater advantages than established ones. The term derivative has a literal meaning. The price at which a derivative contract is traded is derived from the price of the underlying commodity, security, index, or event to which it is related. Derivatives are traded on secondary markets, which, under the influence of purely passive hedging strategies, respond solely to price changes exhibited by the underlying asset in the primary market.

There are two main reasons for the development of markets in derivative products. The first is that they provide opportunities for investors to reduce their risk exposure by hedging their position in a primary market with a countervailing investment in the related secondary market. This enables investors to protect the value of their existing asset holdings without recourse to regulatory devices whose origins are external to the market mechanism. Governments have been keen to promote derivatives markets that are used in this way. The hedging strategies that derivatives markets make possible provide a means of stability and self-governance for the financial system.

The second reason for the development of derivatives markets presents rather more governance dilemmas for public authorities. The demand for a derivative product is a derived demand for the characteristics embodied in it. One obvious characteristic of a new product is that it exists in an unregulated environment. [Page 218]Given the potential for permanent innovation in the provision of financial instruments, regulators will always be one step behind the innovators. Whenever secondary markets have regulatory devices imposed on them, it is possible to create alternative products, which are identical in composition to the newly regulated products, offering the same investment opportunities, but which escape regulation.

One example relates to market regulation enacted through the tax system. Different rates of tax have historically been imposed on different sources of income. Derivatives have been used to translate the return from one income-bearing asset into the return from another. In particular, they have been used to transmute higher-taxed forms of income into lower-taxed forms of income. This has important implications, inter alia, for the likely success of a Tobin tax on short-term currency transactions. Any such tax is likely to be met with concerted financial innovation, whereby it becomes possible to avoid the tax by using a newly created derivative product, which bears all the economic characteristics of short-term currency transactions, but that is untaxed.