Significance of Derivative Market

Derivatives have grown remarkably since their introduction because they help to provide innovative investment products and to manage risk at a considerably lower cost. When you plan a vacation, you do not usually wait until you get to your planned destination to book a room. Booking a hotel room in advance provides assurance that a room will be available and locks in the price. You just need to pay a token or an advance for your booking and not the entire sum. Your action reduces uncertainty (risk) for you. It also reduces uncertainty for the hotel.

Derivatives allow companies and investors to manage future risks related to raw material prices, product prices, interest rates, exchange rates, and even uncontrollable factors, such as weather. They also allow investors to gain exposure to underlying assets while committing much less capital and incurring lower transaction costs than if they had invested directly in the assets.

Other notable uses are –

• Helps in Price discovery – Futures contract prices are a forecast of expected spot prices in the coming days and months. These futures contract prices portray what prices would be acceptable to the market participants in order to avoid uncertainty. Also, we are able to estimate the general level of confidence or fear in the market using volatility. The volatility of the underlying asset can be implied using the option pricing models.
• Lower transaction/substitution costs – The transaction costs of trading derivatives are considerably smaller compared with direct investments. Derivatives thus can effectively substitute for direct investments in underlying assets. Parties are able to get an exposure on the asset only on the basis of an agreement, without having the compulsion to pay for or sell the underlying asset before the contract expiry. By using options, investors can gain exposure to stock or bond markets with a fraction of the capital needed to invest directly in stocks or bonds.
• Operational advantages – Derivative markets are more liquid than spot markets (especially in commodities). One can easily take a short position without owning the underlying. Most importantly, the transaction costs are lower compared to the transaction costs involved in the actual exchange of underlying.
• Risk Management – Derivatives do not eliminate the risk, but they are widely used to transfer various types of risks in the economy from one entity to another, without the need to actually exchange or trade the underlying. When a farmer is taking a short position in the commodity futures, he is establishing a selling price of his produce and is thus hedging the risk of uncertain prices in the future. Thus, the price risk is transferred from the farmer (seller) to the counterparty (buyer), who may be a speculator. Similarly, an investor who already has an exposure to a stock can hedge or mitigate the risk of unfavourable movement by taking a position in a derivative contract that moves in the opposite direction and helps to offset the loss. If you own a stock, you can buy a put option or sell a futures contract in order to hedge the downside risk. Also, an airline company cannot hedge the risk of volatile jet fuel prices in a cost-effective manner except through derivatives. Theoretically, it is possible to buy and store millions of gallons of jet fuel for next year’s operations. But the capital investment and storage costs required for such an undertaking would be formidable. In addition to hedging the risk of movements in raw material prices, derivatives can be used to hedge other kinds of risk, including currency risk, product price risk, and economic risk.
• Improve Market efficiency – If prices deviate from their intrinsic or fundamental values, the arbitrageurs will use derivatives to exploit the mispricing. As the transaction cost and capital requirements are lower, leverage is allowed, and shorting is possible, the ‘Law of one price’ will hold as arbitrage will eliminate the mispricing and make the securities trade near their intrinsic or fair values. If a particular share is undervalued in the stock market relative to the futures market, an investor can buy it in the stock market and sell the related futures contract. Futures and spot market prices will adjust and become better indicators of value. Also, as derivatives promote risk management, more investors are willing to participate in financial markets. This increase in a number of investors also increases the overall liquidity of the market. They help market prices become better indicators of value, which improves resource allocation.
• Provides access to otherwise inaccessible assets or markets – OTC contracts can help any foreign individual or entity to trade in a domestic country’s assets that might otherwise be restricted to outsiders. Foreign Entities can even borrow domestic currency at lower interest rates by using Interest rate swaps or Currency swaps.