Why are Derivatives Important?

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Derivatives are the financial contracts that derive their value from the underlying assets. The value of a derivative depends upon the value of its underlying asset. The underlying assets, in this case, can be stocks, commodities, indices, currencies, rate of interest or exchange rates.

They are the synthetic expressions of their underlying assets and mimic the economics of the asset. Some important types of derivatives are futures, options, forwards and swaps.

Derivative Trading is the trading mechanism in which the traders enter into an agreement to trade at a future date or at a certain price, after understanding what the future value of the underlying asset of the derivative is expected to be.

It is an efficient way for the investors to express their views on the market, at a cost which is much lower than if they were to be trading cash securities.

Now, the most important question – Why are Derivatives Important?

Derivatives are very important contracts, not just from the investors’ point of view but also from the overall economics point of view.

They not only help the investor in hedging his risks, diversifying his portfolio, but also it helps in global diversification and hedging against inflation and deflation.

They have a huge impact on the overall performance of a country’s economy and the world economy.

The world market for derivatives is immense and it has grown extensively in the last couple of decades in both advanced economies and emerging markets.

There are ways in which derivatives form a very important part of the financial infrastructure. They help an investor and the economy in the following ways:

Risk Management:

The relationship between derivatives and risk management is extensive and still simple.

By the use of derivatives, bigger organisations like banks, financial institutions and governments are able to break down their entire risks into smaller elements and these elements can be traded by the investors.

Basically, the overall risk related to an underlying asset is broken down and distributed among the people who are ready to take that risk.

Derivatives help in identifying the desired level of risk and the actual level of risk and align them with each other by means of hedging and speculation. Hedgers transfer their risks to speculators.

For example, when an investor holds a spot position and also holds a future counter position in the same asset, he is offsetting some of the loss on his spot position using the derivatives.

Hedging and speculation can both be done more easily and efficiently using derivatives than with the actual underlying assets.

Price Discovery:

Derivatives play a very crucial role in determining the correct price of a commodity and this is called price discovery. Derivatives markets are affected by the world news and economies and many factors like environment, economy, politics etc. affect the current and future price of the commodities.

Due to all this information and how people process this information, the price of the commodities keeps on changing and helps in price discovery of a commodity.

In particular, futures and forwards provide information about the expected future price and options provide information about the volatility and risk associated with the price of the underlying asset.

Market Efficiency:

Derivative trading involves a lot of arbitrage which brings about price corrections and thus help in reflecting the correct and true economic value and price of the underlying assets.

This helps the markets to remain price efficient and help to achieve equilibrium in the market.

Operational Advantages:

Derivatives play an important role in keeping the transaction costs low in the market. The cost of trading derivatives has to be kept low, thereby bringing down the overall transaction costs of the market.

Derivatives also offer other benefits like bringing liquidity to the market and encouraging short selling.

Therefore, it is well established that derivatives form the backbone of the financial structure of the markets.

They play a very important role for the investors by helping them in risk management, hedging and speculation, along with bringing a huge impact on the entire financial structure of government, a country and the whole world.

Derivatives provide leverage to the market, but at the same time, they give volatility which adds to the overall risk element of the market. So, the traders need to exercise caution and due diligence before entering and trading in the derivatives market.

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