Guide to Analysing Companies

ESSENTIAL FINANCE
01 Essential Finance 10/11/06 2:21 PM Page 6

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and London’s Royal Exchange a century earlier. Whatever the
truth, it is beyond dispute that, in 1865, the Chicago Board of
Trade shaped the first grain futures contract. Thirteen years
later, the London Metal Exchange and the London Corn Trade
Association followed with their own futures contracts. Such
contracts were developed to protect traders from unknown but
expected risks in the future: in the case of grain, the vagaries of
the weather and an uncertain transport system. 
During the past decade or so, the growth of trading in deriva-
tives on organised exchanges has been brisk. Fastest growing
have been derivatives of financial instruments tied to currencies
and exchange rates, interest rates and equities. Since 1995 alone,
the number of contracts of this kind traded on exchanges world-
wide has increased two and a half times. Despite increases in
other markets, particularly in South Korea, US exchanges still
account for the lion’s share of the business, around 35% of all
contracts traded. Together, European exchanges are not far
behind. 
Over the counter
Yet even growth on this scale is dwarfed by the speed with
which trading of financial instruments over the counter (otc),
that is, directly between institutions, has galloped ahead. Ac-
cording to the Bank for International Settlements, which tracks
such things, in 2001 the average daily turnover of otc trading
in derivatives worldwide was more than $760 billion, five times
the level of trading on recognised exchanges throughout the
world. Of this, about one-third was centred on London, the
leader by far in otc trading of this kind.
One reason for the growth in otc trading is the surge in
demand for interest-rate products of one sort or another. The
repayment of US government debt during the Clinton admin-
istration reduced the liquidity of long-term government bonds,
forcing banks and other financial institutions to look for other
ways of hedging their risks in the financial markets. Interest-
rate derivatives, in particular swaps traded directly between
banks and other institutions, seemed to fit the bill. Swaps are
transactions in which two parties (say, a bank and a securities