Introduction

Abstract

During the 1970s and 1980s new financial derivatives were created by global financial intermediaries and exchanges as a means of permitting institutions to capitalize on, or protect against, movements in volatile market references; although derivatives had already existed in basic form for several decades, the market volatility present from the early 1970s onward¹ led to increased participation and innovation in these products. Among the most popular and innovative of the early derivatives (defined as financial contracts which derive their value from movement of underlying reference markets or securities) were standardized exchange-traded futures and options, which gained widespread acceptance during the 1970s, and basic over-the-counter forwards, swaps and options, which gained popularity during the 1980s. Most of the financial derivatives introduced in the 1970s and 1980s are common in the market-place of the 1990s and remain actively used by both end-users (investors and issuers which utilize the products for specific asset or liability purposes) and intermediaries (investment and commercial banks which create, package and trade the products); instruments such as futures (standard exchange contracts which enable participants to buy or sell an underlying asset at a predetermined forward price), forwards (customized off-exchange contracts which enable participants to buy or sell an underlying asset at a predetermined forward price), swaps (customized off-exchange contracts which enable participants to exchange periodic flows based on an underlying reference) and options (standard exchange or customized off-exchange contracts which grant the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined strike price), are employed by issuers, investors and financial intermediaries on a routine basis to achieve specific risk management or investment goals.

We’ve spoken with the client and we’re ready to sell him a two-year, 10 per cent out-of-the-money Asian/average price two-power put on the Hang Seng with a quanto into Deutschmarks; he’ll pay us premium over time, twelve month Deutschmark Libor plus fifty annually.

Derivatives salesman in conversation with his sales manager

I do not for one moment wish to suggest that you have got it all wrong. What I do ask is, are you quite sure you have got it all right?

R. Farrant, Deputy Head of Banking Supervision, Bank of England, March 1992, in an address to participants at International Swaps and Derivatives Association (ISDA) conference