To day we will talking about why derivatives are important

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First, we should know what are derivatives?

In a simple definition, derivatives are financial contracts whose value is linked to the value of an
underlying asset.

why derivatives are important?

Derivatives are very important for investors and a country economy and the world economy and
help in a hedge against inflation and deflation. There are ways in which derivatives are an
important part of the financial infrastructure and they are:

Risk management:

Financial derivatives are used to hedge the risks faced by companies, and there are two roles of
hedging and speculation

Hedging is an attempt to reduce the level of risk associated with the underlying transaction.
Hedgers protect their assets or liabilities from adverse change by entering into a derivative
contract.

Speculative financial risk while predicting gains from market volatility.

Hedging and speculation are two sides of the same coin, so derivatives play a major role in risk
management

Effective use of derivatives reduces risk and increases the rate of return, as it improves the
financial health of the business

The use of financial derivatives has witnessed an increase in risk management locally and
globally

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.

Price discovery:

Derivative market serves as an important source of information about prices. Prices of

derivative instruments such as futures and forwards can be used to determine what the market
expects future spot prices to be. In most cases, the information is accurate and reliable. Thus,
the futures and forwards markets are especially helpful in price discovery mechanism.
Operational advantages:

Derivative markets have greater liquidity than the spot markets. The transactions costs
therefore, are lower. This means commissions and other costs for traders is lower in
derivatives markets. Further, unlike securities markets that discourage shorting, selling short
is much easier in derivatives.

Therefore, by virtue of risk management, short selling, price discovery, and improved
liquidity, derivatives make the markets more efficient.