Economic Benefits of Derivatives

Applications of derivatives

Now that we have learnt the functions and advantages and types of derivatives, here is a closer look on how they are used:

Hedgers: Hedging is a market mechanism by which an investor protects erosion of asset value due to an adverse price movement. Hedgers therefore, use derivatives especially during market volatility. This is to streamline future cash flow and ensure that there is minimal loss of asset value in the future.

So, for example, an investor has a stock portfolio of Rs5 lakh. He may not be keen on liquidating any positions ahead of key macroeconomic events such as budget or monetary policy announcements. He may, therefore, choose to protect his portfolio by shorting index futures. He can also choose to pay a fixed cost in the form of a premium and purchase a put option instead.

Speculators: Speculators, in a way are the exact opposite of hedgers. Rather than protecting their portfolio, they look at making higher gains in a shorter time frame. A speculator may therefore want to take advantage of price movements during times of volatility and make a large profit in the process.

For example, if a speculator has the idea that the price of company A may fall in a few days due to policy announcements, he would choose to short sell the shares of company A ahead of the event. If the fall takes place as per his expectations, he has the opportunity to make a good profit. On the other hand, if the stock price of A rises against his expectations, he will suffer a hefty loss.

Arbitrageurs: The main objective of an arbitrageur is to exploit the price differentials in different markets. He will therefore buy an asset at a cheaper rate in one market and sell it at a higher rate in another. This results in a low risk profit opportunity. However, such windows of opportunities are very brief in the derivatives market and may turn out to be a risky trade.

Benefits:

Underlying Asset price determination

Derivatives are frequently used to determine the price of the underlying asset. For example, the spot prices of the futures can serve as an approximation of a commodity price.

Hedging risk exposure

Since the value of the derivatives is linked to the value of the underlying asset, the contracts are primarily used for hedging risks. For example, an investor may purchase a derivative contract whose value moves in the opposite direction to the value of an asset the investor owns. In this way, profits in the derivative contract may offset losses in the underlying asset.

Market efficiency

It is considered that derivatives increase the efficiency of financial markets. By using derivative contracts, one can replicate the payoff of the assets. Therefore, the prices of the underlying asset and the associated derivative tend to be in equilibrium to avoid arbitrage opportunities.

Access to unavailable assets or markets

Derivatives can help organizations get access to otherwise unavailable assets or markets. By employing interest rate swaps, a company may obtain a more favorable interest rate relative to interest rates available from direct borrowing.