Functions of derivative markets

19/10/2022 0 By indiafreenotes

A Derivatives Market is a financial marketplace where financial instruments, such as options and futures, and other derivative instruments are traded. Different types of investors take part in this market with varying objectives. For instance, some want to earn a profit, some speculate, while some enter the market to hedge their risk.

The derivatives market refers to the financial market for financial instruments such as futures contracts or options that are based on the values of their underlying assets.

Derivatives are financial instruments used for trading in the market whose value is dependent upon one or more underlying assets. It is a security that derived its value from underlying assets such as stocks, currencies, commodities, precious metals, stock indices, etc. Derivatives represent a contract that is entered into by two or more parties.

This contract is regarding the money payments and sell/purchase of assets between the parties. There are certain conditions which are attached to this contract while entering into such as contractual obligations of parties, date of maturity, notional amount and resulting values of underlying instruments. Derivative instruments are mainly used for hedging the risk or earning profit through speculation on value of underlying security.

These instruments are either traded over the counter or via an exchange. Over-the-counter (OTC) derivatives are one which is traded privately and without any intermediary whereas exchange-traded derivatives are traded via specialized exchanges such as Bombay stock exchange. Futures, forwards, options and swaps are four main types of derivative instruments.


Transfer Of Risk

Derivatives are used for transferring the risk from one party to another that is a buyer of a derivative product to the seller. It is an effective risk management tool that transfers the risk from those having a low-risk appetite to those having a high-risk appetite.

Price Discovery

Derivative contract helps in determining the prices of the underlying assets. Future and forward contract prices are used in determining the future spot prices for the commodity. This way it is beneficial in discovering the prices for underlying assets.

Hedging Risk

It helps in hedging risk against unfavorable price movements of an underlying asset. By entering into a forward contract, the buyer and seller agrees to complete the deal at a pre-decided price at some specific date in the future. Any unexpected price hikes or drop will not influence the contract value, thereby providing protection against these types of risks.

Provide Access to Unavailable Assets And Markets

Derivative enables business in reaching out to hard to trade assets and markets. Organizations with the application of interest rate swaps can obtain better interest rates than available in the current market.

Lower Transaction Cost

The cost of trading in derivative instruments is quite low as compared to other segments in financial markets. They act as a risk management tool and thereby lower the transaction costs of the market.

Higher Leverage

Derivatives instruments provide higher leverage than any other instrument available in the financial market. Capital required to take positions in derivative instruments is very low as compared to the stock market. In the case of a future contract, only 20-40% of the contract value is needed whereas, in case of options, only the amount of premium is required for trading.