ISDA highlights a selection of research papers on derivatives and risk management         

FX Option Volume

Bank of England Staff Working Paper
By Robert Czech, Pasquale Della Corte, Shiyang Huang, and Tianyu Wang

The study examines the relationship between the volume of foreign exchange (FX) options traded over-the-counter and future exchange returns. The analysis is based on transactions reported to the Depository Trust & Clearing Corporation derivatives repository.

The analysis shows a negative relationship between aggregate option volume and future exchange rate fluctuations, which means higher option volumes observed today predict a foreign currency depreciation (or a US dollar appreciation) tomorrow. This relationship is stronger when the initial demand for US dollars is higher.

The authors argue that certain investors in the FX options market seem to have superior information on future exchange rate returns. The analysis separates interdealer from dealer-client transactions and shows dealer-client volume is a more powerful predictor than interdealer volumes for future exchange rate returns. Within the client sector, the option volumes of both hedge funds and real money investors strongly predict future FX returns.

The study shows the return predictability is stronger when using options with higher embedded leverage, such as out-of-the-money options or short-maturity options. The analysis also demonstrates that exchange rate predictability is stronger around macro-announcement days.

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Climate-related Transition Risk in the European CDS Market

Hanken School of Economics; European Central Bank; University of Helsinki – Helsinki Graduate School of Economics; Leibniz Institute for Financial Research SAFE
By Katia Vozian

The paper analyzes the relationship between European firms’ exposure to climate-related transition risk and their market-implied credit risk measured by single-name credit default swap (CDS) spreads over different time horizons. A higher CDS spread indicates greater perceived credit risk for a reference entity.

Transition risk results from the process of adjustment towards a lower-carbon economy. Exposure to transition risk may affect the credit risk of a firm by affecting its revenue, operating costs, debt and the value of its assets.

The author measures transition risk by considering the level of a firm’s greenhouse gas (GHG) emissions, transition risk management indicators (including past performance and future commitment) and exposure to the EU Emission Trading System (EU ETS).

The study finds that firms with higher Scope 1 GHG emissions have higher CDS-implied credit risk. Scope 1 emissions are GHG emissions that occur from sources that are controlled or owned by the company.

The results of the study suggest the European CDS market is already pricing in information on Scope 1 emissions to some extent. However, information on a firm’s transition risk management efforts and its exposure to the EU ETS is not reflected by CDS market participants.

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The Global Market for Exchange-traded Derivatives: 21st Century Trends, Innovation and Failure

Forthcoming, Applied Finance Letters
By Ekaterina E. Emm, Gerald D. Gay, Han Ma and Honglin Ren

The study examines trends in trading activity and product innovation in the global market for exchange-traded derivatives over the past two decades. The analysis is based on monthly futures and options trade activity executed on 110 exchanges in 40 countries.

Between 2002 and 2021, global trading volume of exchange-traded derivatives increased by approximately 10 times, while open interest increased by about 2.3 times. Futures volume and open interest increased by 12.6 and 5.7 times, while options volume and open interest increased by 8.9 and 2.6 times, respectively.

The market share of major geographic trading regions changed over time. In 2002, Europe and North America dominated futures trading with market shares of 41% and 34%, respectively, based on monthly trading volume. Asia market share totaled 17%, while Latin America had only 8% of global futures trading activity. By 2021, market shares for Europe and North America declined to 17% each, while Asia increased to 35% and Latin America grew to 24%.

Based on futures open interest, North America and Europe maintained their dominant market share at 30% and 27% in 2021. Asia’s market share was 18% and Latin America’s market share was 16%. The difference in market share by trading volume and open interest suggests a large increase in turnover.

While there was significant growth in all asset classes, equity and currency derivatives showed the largest rise, while interest rate derivatives increased the least. Based on trading volume in 2021, equity futures accounted for 44% of all futures volume, and interest rate futures, currency futures and agriculture futures totaled 15%, 13% and 10%, respectively.

The study also analyzes the growth of new contract innovation and the failure rate of both legacy and innovation contracts. The authors find that North American exchanges accounted for 43% of all new contracts, while Europe and Asia totaled 28% and 20%, respectively.

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