Ingrained Volatility Led to Development of Financial Derivative Instruments

Recently the trading of commodity derivatives has made news, particularly in regards to a how Chesapeake Energy used derivatives to both hedge and speculate in energy markets. As is often the case when discussion of derivatives comes up, many misconceptions arise.

It must be noted that the use of commodities derivatives for both hedging and speculative purposes has been around for hundreds of years and is an ingrained tool of doing business in many commodities markets. The rise of derivatives markets originally gained footing in the US in the 1800s when farmers were looking for ways to protect themselves from the volatile swings in prices that weather related events had on their crops. This ingrained volatility in agricultural markets led to the development of financial derivative instruments that allowed users of the underlying market (farmers, consumers) to offset their risk onto speculators who took on the price risk. This symbiotic relationship between those who have natural exposure to price risk due to their underlying business and those who are looking to gain exposure to volatile price movement’s lead to the development of commodity futures exchanges such as the Chicago Board of trade, NY Board of trade etc…

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