Derivatives, Volatility and Price Discovery

Benjamin Cohen

International Finance, 1999, vol. 2, issue 2, 167-202

Abstract: It is sometimes suggested that trading in derivatives leads to excessive volatility in underlying asset prices relative to what would be called for by fundamental values. These effects are tested by comparing the variances of price changes over different time horizons before and after the start of organized derivatives trading. It is found that ratios of the variances of multi‐day and daily price movements decline for bond prices in the United States and Germany and for stock indices in the US, Japan and the UK, though no such effect is found for Japanese bonds. Other indicators confirm that serial correlation has tended to decline since the introduction of derivatives. While these results offer strong grounds for rejecting predictions of the destabilizing effects of derivatives, an alternative view, that derivatives accelerate the price‐discovery functions of cash markets, cannot be definitively confirmed, given ambiguous breakpoint results and the many other contemporaneous developments in financial technology.

Date: 1999
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