Despite the fear and criticism with which the derivative markets are commonly looked at, these markets perform several economic functions:
1. Management of Risk
Financial derivatives facilitate the efficient management of financial risks and can help ensure that value-enhancing opportunities are not overlooked. Risk management is not about eradicating risk; instead, it pertains to risk management.
Financial derivatives serve as a robust tool for curtailing risks that individuals and organisations face in the normal conduct of their businesses. It necessitates a comprehensive understanding of the rudimentary principles that govern the pricing of financial derivatives.
The effective utilisation of derivatives can curtail costs, and it can elevate returns for organisations.
2. Exploit Opportunities to Enhance Returns
Derivative securities such as options, forwards, futures, and swaps can enable firms and investors to exploit opportunities to enhance returns that might not otherwise be available.
Derivatives assist in the allocation of risk between investors and firms, reducing the costs of portfolio diversification. The prices of derivatives reveal vital information to investors, contributing to stabilising financial markets.
Investors and firms can engage in derivative contracts to speculate on securities and indexes. This involves adopting a market position that offers a potential pattern of future payoffs when a change in prices or interest rates is anticipated.
Derivatives facilitate the completion of markets, which is highly desirable as they offer maximum flexibility for investors. They provide opportunities to achieve any possible pattern of returns by using a portfolio of existing securities.
Moreover, a complete market is economically efficient. This implies that resources cannot be reallocated in a manner that would benefit everyone more significantly.
3. Price Discovery
Price discovery involves unveiling information about future cash market prices through the futures market. Derivatives markets offer a mechanism whereby diverse and scattered viewpoints about the future are collected into one easily discernible number. This provides a consensus of informed thinking.
4. Price Stabilisation
The derivatives market contributes significantly to stabilising the influence on spot prices by moderating short-term fluctuations. In effect, derivatives dampen both the peaks and troughs, leading to a stabilising effect on the cash market for the underlying assets.
5. Efficiency in Trading
Financial derivatives facilitate the free trading of risk components, thereby enhancing market efficiency. Traders can utilise a position in one or more financial derivatives as an alternative to a position in the underlying instruments.
In numerous instances, traders perceive financial derivatives to be more appealing than the underlying security. This is primarily due to the abundant liquidity offered by derivatives in the market and the reduced transaction costs related to trading a financial derivative compared to the costs of trading the underlying instrument in the cash market.
Financial derivatives are frequently considered to be risky. If not managed appropriately, they can lead to severe financial disruption within an organisation. Nevertheless, these instruments serve as a potent tool for knowledgeable traders, enabling them to expose themselves to calculated and thoroughly understood risks in pursuit of a reward, namely, profit.
7. Higher Trading Volumes
Derivatives, given their inherent characteristics, are intrinsically connected to the underlying cash markets. The advent of derivatives leads to a surge in trading volumes in the primary market as they attract a broader spectrum of participants. These players may have previously abstained from participation due to the absence of a suitable mechanism to transfer risk.
8. Control Market Activities
Speculative trades transition to a more regulated environment in the derivatives market. Without an organized derivatives market, speculators conduct trades in the underlying cash markets. The task of managing, monitoring, and overseeing the activities of various participants becomes exceedingly challenging in these types of mixed markets.
9. Acts as Catalyst
An integral, incidental benefit that emanates from derivatives trading is its role as a catalyst for new entrepreneurial activity. Derivatives have a rich history of attracting many bright, creative, and well-educated individuals with an entrepreneurial mindset.
These individuals often inspire others to establish new businesses, devise innovative products, and create fresh employment opportunities, the benefits of which are immense. In a nutshell, derivatives markets contribute to augmenting savings and investments in the long run. The transfer of risk allows market participants to broaden their spectrum of activities.