BENEFITS OF DERIVATIVES

Derivative markets help investors in many different ways:

1.] RISK MANAGEMENT –

Futures and options contract can be used for altering the risk of investing in spot market. For instance, consider
an investor who owns an asset. He will always be worried that the price may fall before he can sell the asset. He
can protect himself by selling a futures contract, or by buying a Put option. If the spot price falls, the short
hedgers will gain in the futures market, as you will see later. This will help offset their losses in the spot market.
Similarly, if the spot price falls below the exercise price, the put option can always be exercised.

Derivatives markets help to reallocate risk among investors. A person who wants to reduce risk, can transfer some
of that risk to a person who wants to take more risk. Consider a risk-averse individual. He can obviously reduce risk
by hedging. When he does so, the opposite position in the market may be taken by a speculator who wishes to take
more risk. Since people can alter their risk exposure using futures and options, derivatives markets help in the
raising of capital. As an investor, you can always invest in an asset and then change its risk to a level that is more
acceptable to you by using derivatives.

2.] PRICE DISCOVERY –

Price discovery refers to the markets ability to determine true equilibrium prices. Futures prices are believed to
contain information about future spot prices and help in disseminating such information. As we have seen,
futures markets provide a low cost trading mechanism. Thus information pertaining to supply and demand
easily percolates into such markets. Accurate prices are essential for ensuring the correct allocation of resources
in a free market economy. Options markets provide information about the volatility or risk of the underlying
asset.

3.] OPERATIONAL ADVANTAGES –

As opposed to spot markets, derivatives markets involve lower transaction costs. Secondly, they offer greater
liquidity. Large spot transactions can often lead to significant price changes. However, futures markets tend to
be more liquid than spot markets, because herein you can take large positions by depositing relatively small
margins. Consequently, a large position in derivatives markets is relatively easier to take and has less of a price
impact as opposed to a transaction of the same magnitude in the spot market. Finally, it is easier to take a short
position in derivatives markets than it is to sell short in spot markets

4.] MARKET EFFICIENCY –

The availability of derivatives makes markets more efficient; spot, futures and options markets are inextricably
linked. Since it is easier and cheaper to trade in derivatives, it is possible to exploit arbitrage opportunities
quickly and to keep prices in alignment. Hence these markets help to ensure that prices reflect true values.

5.] EASE OF SPECULATION –

Derivative markets provide speculators with a cheaper alternative to engaging in spot transactions. Also, the
amount of capital required to take a comparable position is less in this case. This is important because
facilitation of speculation is critical for ensuring free and fair markets. Speculators always take calculated risks.
A speculator will accept a level of risk only if he is convinced that the associated expected return is
commensurate with the risk that he is taking.

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The derivative market performs a number of economic functions.
• The prices of derivatives converge with the prices of the underlying at the expiration of derivative
contract. Thus derivatives help in discovery of future as well as current prices.
• An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new
entrepreneurial activity.
• Derivatives markets help increase savings and investment in the long run. Transfer of risk enables
market participants to expand their volume of activity.

Flexibility:
Derivatives can be used with respect to commodity price, interest and exchange rates and equity price. They can
be used in many ways.

Risk Reduction:
Derivatives can protect your business from huge losses. In fact, derivatives allow you to cut down on non-
essential risks.

Stable Economy:
Derivatives have a stabilizing effect on the economy by reducing the number of businesses that go under due to
volatile market forces.

A tool for hedging:

Derivatives provides an excellent mechanism to hedge the future price risk. Think of a farmer, who doesn't
know what price he is going to get for his crop at the time of harvest. He can sell his crop in the futures' market
& lock in the price. If the future spot price is more than the futures price, he can take the off setting position &
can get out of the market (with a marginal loss). Otherwise he will get the locked in price.

Better avenues for raising money: With the introduction of currency & interest rate swaps, Indian corporate
will be able to raise finance from global markets at better terms.

Increasing the depth of financial markets: When a financial market gets such sort of risk-management tools,
its depth increases since the Institutional Investors get better ways of hedging their risks against unfavorable
market movements.

Derivatives market on Indian underlying elsewhere: These days, with the advent of technology, Indian
prices are available globally on Reuters & Knightrider. Nothing prevents any foreign market from launching
derivatives on these Indian underlying. This will put Indians in a disadvantageous position as they can't take the
advantages of derivatives of securities or commodities traded in India but someone lese can take. So we will
have to move fast in this direction.