Mar 18, 2009
What is the role of various derivatives instruments in maintaining an efficient market?

EFF: Theoretically, derivatives increase the range of bets people can make, and this should help to wipe out potential inefficiencies. Whether this actually happens is a difficult, perhaps impossible, empirical question. The "problem" is that markets seemed rather efficient before Black-Scholes (which initiated the derivatives industry), so there wasn't much for derivatives to do.

KRF: Derivatives can also reduce the cost of making bets. It is much cheaper to trade an S&P 500 futures contract, for example, than to buy shares in all 500 companies. In many markets, derivatives have a particularly large effect on the trading costs of investors who want to go short, betting that prices will go down.

A reduction in trading costs makes it less expensive for active investors to gather information and trade on it. The result is likely to be more accurate prices. This does not mean there would be more profit opportunities without derivatives—remember, prices would be less accurate precisely because it is would cost more to exploit perceived mistakes—but financial markets would provide less valuable signals to the rest of society.

Eugene F. Fama
The Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business
Kenneth R. French
The Roth Family Distinguished Professor of Finance at the Tuck School of Business at Dartmouth College
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Eugene Fama and Ken French are members of the Board of Directors of the general partner of, and provide consulting services to Dimensional Fund Advisors LP.