For decades, the role of futures markets in stabilizing or destabilizing prices on the spot market has been a subject of much controversy, not only among economists but also with the general public. What used to be a controversy about futures trading has, with the growth of new and more complex derivatives, become a controversy about derivatives in general.

Price stabilization, as mentioned in Chapter 4, is claimed by some economists to be one of the useful economic functions of futures trading in particular and, by extension, of derivatives in general. This chapter looks at how derivatives influence spot prices and at the theoretical basis for derivatives to exercise a stabilizing influence on prices. It then touches upon empirical studies supporting this view.

Do derivatives affect spot prices?

The first question that arises is whether and, if so, how transactions in the derivatives markets affect prices on the cash (spot) markets. After all, the overwhelming majority of derivatives transactions does not result in receipt or delivery of the underlying. The transactions are settled between the two parties merely by paying up the net price difference. Many economists and laymen have often compared the derivatives markets to mere betting markets and indeed (as was seen in Chapter 2) there are good reasons to compare them. Let it be supposed that there are bookmakers who take bets on the outcome of a football match. Clearly – and assuming there is no ‘match-fixing’ by players or coaches – the bets on the game must have no effect whatsoever on the outcome of the game.