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 allow for the efficient management of financial risks and can help to ensure that value-enhancing opportunities will not be ignored. Risk management is not about eliminating risk; rather, it is about the management of risk.
Financial derivatives provide a powerful tool for limiting risks that individuals and organizations face in the ordinary conduct of their businesses. It requires a thorough understanding of the basic principles that regulate the pricing of financial derivatives.
Effective use of derivatives can save costs, and it can increase returns for the organizations.
2) Exploit Opportunities to Enhance Returns: Derivative securities such as options, forwards and futures, and swaps can provide firms and investors to exploit opportunities to enhance returns that might not otherwise be available.
Derivatives aid in the allocation of risk across investors and firms, and they lower the costs of diversifying portfolios. Derivative prices reveal information to investors that can make financial markets more stable.
It makes investors and firms to enter into the derivative contracts to speculate on securities and – indexes, which involve taking a market position which provides them a conceivable pattern of payoffs in the future when a change in prices or interest rates is expected.
Derivatives make complete markets that are very desirable because they provide maximum flexibility for investors and give them opportunity to achieve any possible pattern of returns by using a portfolio of existing securities.
Also, the complete market is economically efficient, which means that resources cannot be reallocated in such a way as to make everyone better off.
3) Price Discovery: Price discovery means revealing information about future cash market prices through the futures market. Derivatives markets provide a mechanism by which diverse and scattered opinions of the future are collected into one readily discernible number, which provides a consensus of knowledgeable thinking.
4) Price Stabilisation: Derivatives market helps to keep a stabilizing influence on spot prices by reducing the short-term fluctuations. In other words, derivative reduces both peak and depths and leads to a price stabilization effect in the cash market for the underlying assets.
5) Efficiency in Trading: Financial derivatives allow for free trading of risk components, and that leads to improving market efficiency. Traders can use a position in one or more financial derivatives as a substitute for a position in the underlying instruments.
In many instances, traders find financial derivatives to be a more attractive instrument than the underlying security. This is mainly because of the greater amount of liquidity in the market offered by derivatives and the lower transaction costs associated with trading a financial derivative compared to the costs of trading the underlying instrument in the cash market.
6) Speculation: Financial derivatives are considered to be risky. If not used properly, these can leads to financial destruction in an organization. However, these instruments act as a powerful instrument for knowledgeable traders to expose themselves to calculated and well-understood risks in search of a reward, i.e., profit
7) Higher Trading Volumes: Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.
8) Control Market Activities: Speculative trades shift to a more controlled environment of the derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Managing, monitoring, and surveillance of the activities of various participants become extremely difficult in these kinds of mixed markets.
9) Acts as Catalyst: An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude.
They often energize others to create new businesses, new products, and new employment opportunities, the benefit of which is immense. In a nutshell, derivatives markets help to increase savings and investment in the long-run. Transfer of risk enables market participants to expand their volume of activity.