The Benefits of Derivatives

1) Risk allocation, transfer and management

  • Derivatives allow trading the risk without trading the instrument itself

  • Derivatives provide an effective method of transferring risk from parties who do not want the risk to parties who do

2) Information discovery

  • Derivatives markets can convey information not impounded in the spot market. This is due to the fact that derivatives require less capital, information can flow into the derivatives market before it gets into the spot market. This provides an edge to an astute trader.

  • Derivatives convey another simple piece of information: What price would one accept to avoid uncertainty. As such, derivatives reveal the price that the holder of an asset could take and avoid the risk.

  • Options provide information about what investors think of the uncertainty in the market.

3) Operational advantages

  • Derivatives have lower transactional costs than the underlying

  • Derivative markets typically have greater liquidity than the underlying market

  • With derivatives, it is nearly as easy to take a short position as to take a long position, whereas for the underlying asset, it is almost always much more difficult to go short than to go long.

4) Market efficiency

  • When prices deviate from fundamental values, derivatives offer less costly ways to exploit the mispricing.

All these advantages of derivatives make the financial markets function more effectively. Investors and traders are far more willing to trade if they can more easily manage their risk, trade at lower cost and with less capital and go short more easily. The increase willingness to trade increases the number of market participants, thus making the market more liquid.

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