Financial Management of Risks 433SIZE OF THE DERIVATIVE MARKET
AND WIDESPREAD USE
A derivative is a financial instrument whose value or contingent cash flows de-
pend on the value of some other underlying asset. For example, the value of a
stock option depends on the value of the underlying stock. Derivatives as a
class comprise for wards, futures, options, and swaps. Numerous hybrid instru-
ments, combining the features of these basic building blocks have also been
engineered. The first thing the interested manager must understand about de-
rivatives is that the business in these instruments is now huge, and their use is
pervasive. Since the initiation of trading in the first stock index futures con-
tract in December of 1982—the Standard & Poor ’s 500 futures contract—the
daily volume of stock index futures has grown so that it now rivals the daily
volume in all trading on the New York Stock Exchange. (Volume of futures is
measured in terms ofnotional principal,which is a measure of exposure.) On
just one typical day in the 1990s, Tuesday, January 21, 1996, the notional vol-
ume of the Standard & Poor ’s 500 futures contract was just shy of $40 billion.
The volume on the NYSE that same day was approximately $23 billion. On that
day, therefore, just one specific futures contract was greater than the entire
Big Board stock market in terms of trading volume. More recently, however,
the tables have turned, and the New York Stock Exchange daily trading volume
once again regularly beats that of the S&P 500 futures contract. Still the mag-
nitudes are comparable, and futures trading is firmly established as a signifi-
cant segment of financial market activ ity.
Similarly, the swaps market has revolutionized banking and finance. The
notional principal of outstanding swaps today, is greater than the sum total of
all assets in banks worldwide. The Bank for International Settlements reports
that the sum total of all assets in banks around the world was approximately
$12 trillion in June 2000. At that same time, according to the same source, the
notional principal of outstanding swaps was over $50 trillion. Measured this
way, the swaps business is now bigger than traditional banking.
The volume of the derivatives market ref lects how widespread deriva-
tives use has become in business. Almost all major corporations now use them
in one form or another. Some use derivatives to hedge commodity price risks.
Some use them to speculate on price movements. Some firms reduce their ex-
posures to volatile interest rates and foreign exchange. Other firms take on
exposures via derivatives in order to potentially increase profits. Some firms
use derivatives to secure cheaper financing. Many corporations use derivatives
to reduce the transaction costs associated with managing a pension fund, bor-
rowing money, or budgeting cash. Some firms implement derivative strategies
to reduce their tax burdens. Many companies offer stock options, a derivative,
as employee compensation. Some investment funds enhance returns by replac-
ing traditional portfolios with what are called synthetic portfolios—portfolios
composed in part of derivatives. Some investment funds buy derivatives that
act as insurance contracts, protecting portfolio value. Since their emergence in