Chapter 19 Derivatives

The area of derivatives is arguably the most fascinating area within financial economics during the past thirty years. This chapter reviews the evolution of derivatives contract markets and derivatives research over the past thirty years. The chapter has six complementary sections. The first contains a brief history of contract markets. The most important innovations occurred in the 1970s and 1980s, when contracts written on financial contracts were introduced. Concurrent with these important industry innovations was the development of modern-day option valuation theory, which is reviewed in the second and third sections. The key contribution is seminal theoretical framework of the Black-Scholes (1973) and Merton (1973) (“BSM≓) model. The key economic insight of their model is that a risk-free hedge can be formed between a derivatives contract and its underlying asset. This implies that contract valuation is possible under the assumption of risk-neutrality without loss of generality. The final three sections summarize the three main strands of empirical work in the derivatives area. In the first group are studies that focus on testing no-arbitrage pricing relations that link the prices of derivatives contracts with their underling asset and with each other. The second group contains studies that evaluate option empirical performance of option valuation models. The approaches used include investigating the in-sample properties of option values by examining pricing errors or patterns in implied volatilities, examining the performance of different option valuation models by simulating a trading strategy based on under- and over-pricing, and examining the informational content of the volatility implied by option prices. The final group focuses on the social costs and/or benefits that arise from derivatives trading. The main conclusion that can be drawn from the empirical work is that the BSM model is one of the most resilient in the history of financial economics.