A Theory of the Evolution of Derivatives Markets

Publication Date
Financial Markets Group Discussion Papers DP 723
Publication Authors


This paper develops a theory of the opening and dynamic development of a futures market with competing exchanges. The optimal contract design involves a trade-off between the hedging potential of a contract and its degree of substitution with competing contracts. As design costs go down slowly, more exchanges enter, but if costs go down fast or reach zero, markets consolidate (fewer number of exchanges). I develop implications for how the hedging potential and cross-correlation between contracts develop over time.

I extend the model to a case where demand is uncertain before trade has been observed, and perform comparative statics on the social efficiency of market opening. For markets with equivalent expected surplus, the propensity of markets to open are negatively related to the probability of further entry and the ex ante uncertainty, and positively related to the time lag between innovations.