Functions of Derivatives

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.

Functions of Derivatives

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.

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.

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.

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.

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.

Advantages of Derivatives

Hedging Risk

Derivative contracts are used for hedging risk arising out of fluctuations in price movements. Value of
these contracts is dependent upon the value of underlying assets. Investor will purchase those
derivative contracts whose value moves opposite to the value of security the investor owns. Therefore,
losses in underlying commodities may be offset by profit in contracts of derivatives.
Determine Underlying Asset Price

Derivatives contracts helps in ascertaining the price of underlying assets. An approximation of

commodity prices is known through the spot prices of future contracts.

Provide Access To Unavailable Market Or Asset

Another important advantage of derivative is that it provides access to unavailable market and assets to
peoples. Individuals can acquire funds at lower or favorable rate of interest as compared to direct
borrowings with the help of interest rate swaps.

Enhance Market Efficiency

Derivatives plays an efficient role in improving the financial market’s efficiency. These contracts are used
for replicating the assets payoff. It enables in getting fair and correct economic value of underlying
commodity as these contracts brings price corrections via arbitrage. This way market becomes price
efficient and an equilibrium is attained.

Low Transaction Cost

Trading of these instruments involves low transaction cost which is beneficial for investors. This acts as a
risk management tool and a protection against price fluctuations. Cost of trading in derivatives is lower
as compared to other securities like shares or debentures.

Disadvantages of Derivatives

High Risk

Derivatives contracts are exposed to high degree of risk due to high volatile price of underlying
securities. Prices of these underlying securities like shares or metals keeps on changing rapidly as
derivatives are mostly traded in open market. This involves a high degree of risk.

Counter Party Risk

There is a possibility of default on the part of counter-party in case of derivatives traded over the
counter due to lack of due diligence process. OTC derivatives as compared to exchange derivatives lacks
a benchmark for due diligence.

Speculative Features

Derivatives are instrument which are used for speculation purpose for earning profits. Sometimes huge
losses may occur due to unreasonable speculation as derivatives are of unpredictable and high risky
nature.

Requires Expertise

This is one of the major drawbacks in trading of derivative instruments. Investor’s requires high
knowledge and expertise for trading in these instruments as compared to other securities likes stocks
and metals.