Advantages of Derivatives: 1.

Price Discovery Futures market prices depend on a continuous flow of information from around the world and require a high degree of transparency. A broad range of factors (clim atic conditions, political situations, debt default, refugee displacement, land reclamation and environmental health, for example) impact supply and demand of a ssets (commodities in particular) - and thus the current and future prices of th e underlying asset on which the derivative contract is based. This kind of infor mation and the way people absorb it constantly changes the price of a commodity. This process is known as price discovery. o With some futures markets, the underlying assets can be geographically d ispersed, having many spot (or current) prices in existence. The price of the co ntract with the shortest time to expiration often serves as a proxy for the unde rlying asset. o Second, the price of all future contracts serve as prices that can be ac cepted by those who trade the contracts in lieu of facing the risk of uncertain future prices. o Options also aid in price discovery, not in absolute price terms, but in the way the market participants view the volatility of the markets. This is bec ause options are a different form of hedging in that they protect investors agai nst losses while allowing them to participate in asset s gain. 2. Risk Management This could be the most important purpose of the derivatives market. Risk managem ent is the process of identifying the desired level of risk, identifying the act ual level of risk and altering the latter to equal the former. This process can fall into the categories of hedging and speculation. Hedging has traditionally b een defined as a strategy for reducing the risk in holding a market position whi le speculation referred to taking a position in the way the markets will move. T oday, hedging and speculation strategies, along with derivatives, are useful too ls or techniques that enable companies to more effectively manage risk. 3. They Improve Market Efficiency for the Underlying Asset For example, investors who want exposure to the S&P 500 can buy an S&P 500 stock index fund or replicate the fund by buying S&P 500 futures and investing in ris k-free bonds. Either of these methods will give them exposure to the index witho ut the expense of purchasing all the underlying assets in the S&P 500. If the cost of implementing these two strategies is the same, investors will be neutral as to which they choose. If there is a discrepancy between the prices, i nvestors will sell the richer asset and buy the cheaper one until prices reach e quilibrium. In this context, derivatives create market efficiency. 4. Derivatives Also Help Reduce Market Transaction Costs Because derivatives are a form of insurance or risk management, the cost of trad ing in them has to be low or investors will not find it economically sound to pu rchase such "insurance" for their positions. 3. Provide Leveraging: In order to take position in derivatives, you require very small initial outlay of capital i n comparison to taking position in the spot market. Assume that Mr. A believes t hat price of rice shall be Rs. 50/kg in 3 months from now and that a farmer has agreed to sell it at Rs. 49/kg. To take this benefit, Mr. A has to pay full amou nt of Rs. 49/kg today and he will realize Rs. 50/kg 3 months later. Instead, if there is a way through which he can escape making a full payment, he shall be re ally glad to enter into such contract and Derivatives provide those exit routes by letting one enter into a contract and can neutralize their position by bookin g opposite position on a future date. 4. Completion of Market/Efficient Market: A market is efficient or said to be co mplete market (theoretically possible) when the available instruments can by its elf or jointly provide cover against any possible adverse outcomes. It is a theo retical concept, which is not seen in practice. Though with the presence of deri vatives, there is a greater degree of market completeness. Below mentioned are d isadvantages/ demerits of Derivatives:

1. Raises Volatility: As a large no. of market participants can take part in der ivatives with a small initial capital due to leveraging derivatives provide, it leads to speculation and raises volatility in the markets. 2. Higher no. of Bankruptcies: Due to leveraged nature of derivatives, participa nts assume positions which do not match their financial capabilities and eventua lly lead to bankruptcies. 3. Increased need of regulation: Large no. of participants take positions in der ivatives and take speculative positions. It is necessary to stop these activitie s and prevent people from getting bankrupt and to stop the chain of defaults.