financial derivative

A financial derivative is an agreement to set the price of an investment based on the value of
another asset. For example, when you purchase currency futures based on a specific exchange
rate, the value of the futures will change as that currency’s exchange rate changes.
The concept of financial derivatives is not commonly used by the general public. They are
typically used by large investors to manage risk. There are two key concepts about financial
derivatives:
 They help create leverage, so that an object can be related in terms of other values and you
can minimize risk.
 They are used to either take on more risk or reduce risk, depending on what kind of
contractual agreement is made.
The concept of a financial derivative can be difficult to understand, so looking at some
examples may help.

Examples of Financial Derivatives

The contractual setup between an investment asset and a share of stock or currency is
characteristic of the concept of financial derivatives. The price of both should move in
tandem, directly related to the increase or decrease in value of the financial derivative.
Derivatives are things that cannot stand alone in terms of value - the value is directly related
to something else in the economy. For example these investment assets are commonly used
as financial derivatives:
 Stocks
 Bonds
 Commodities
 Futures
 Swaps
 Options
 Currency rates
 Interest rates
 Market indexes
With the underlying value of an asset is established, it is almost impossible to conceive of
how much that asset is worth without an understanding of the value of the asset to which it is
dependent as a derivative. You can think of what the face value of an object could be, but its
true value would be determined using complicated mathematical formulas to separate the
asset’s value from the asset.

Terms Related to Financial Derivatives

There is a lot of financial jargon and terms to learn in order to understand financial
derivatives. Here are some tips to help you understand the terms:
 Consider the kind of relationship between the underlying investment asset and the
derivative. Relationships could be a "forward," "swaps" or "options."
 Consider what kind of market the underlying investment and the derivative trade in. They
could be exchanged in a trade in the stock market, or they might be traded person-to-person
or “over the counter.”

What Is a Financial Derivative?

Derivatives are securities which are linked to other securities, such as stocks or bonds. Their
value is based off of the primary security they are linked to, and they are therefore not worth
anything in and of themselves.
There are literally thousands of different types of financial derivatives. However, most
investment and financial engineering strategies revolve around the following three:
1. Options
Options are contracts between two parties to buy or sell a security at a given price.
They are most often used to trade stock options, but may be used for other
investments as well. If an investor purchases the right to buy an asset at a particular
price within a given time frame, he has purchased a call option. Conversely, if he
purchases the right to sell an asset at a given price, he has purchased a put option.
2. Futures
Futures work on the same premise as options, although the underlying security is
different. Futures were traditionally used for purchasing the rights to buy or sell a
commodity, but they are also used to purchase financial securities as well. It is
possible to purchase an S&P 500 index future, or a future associated with a particular
interest rate.
3. Swaps
Swaps give investors the opportunity to exchange the benefits of their securities with
each other. For example, one party may have a bond with a fixed interest rate, but is
in a line of business where they have reason to prefer a varying interest rate. They
may enter into a swap contract with another party in order to exchange interest rates.

Advantages of Derivatives
Derivatives are sound investment vehicles that make investing and business practices more
efficient and reliable.
Here are a few reasons why investing in derivatives is advantageous:
1. Non-Binding Contracts
When investors purchase a derivative on the open market, they are purchasing the
right to exercise it. However, they have no obligation to actually exercise their option.
As a result, this gives them a lot of flexibility in executing their investment strategy.
That being said, some derivative classes (such as certain types of swap agreements)
are actually legally binding to investors, so it’s very important to know what you’re
getting into.
2. Leverage Returns
Derivatives give investors the ability to make extreme returns that may not be
possible with primary investment vehicles such as stocks and bonds. When you invest
in stock, it could take seven years to double your money. With derivatives, it is
possible to double your money in a week.
3. Advanced Investment Strategies
Financial engineering is an entire field based off of derivatives. They make it possible
to create complex investment strategies that investors can use to their advantage.

Potential Pitfalls
The concept of derivatives is a good one. However, irresponsible use by those in the financial
industry can put investors in danger. Famed investor Warren Buffet actually referred to them
as “instruments of mass destruction” (although he also feels many securities are mislabeled as
derivatives).
Investors considering derivatives should be wary of the following:
 1. Volatile Investments
Most derivatives are traded on the open market. This is problematic for investors,
because the security fluctuates in value. It is constantly changing hands and the party
who created the derivative has no control over who owns it. In a private contract, each
party can negotiate the terms depending on the other party’s position. When a
derivative is sold on the open market, large positions may be purchased by investors
who have a high likelihood to default on their investment. The other party can’t
change the terms to respond to the additional risk, because they are transferred to the
owner of the new derivative. Due to this volatility, it is possible for them to lose their
entire value overnight.
2. Overpriced Options
Derivatives are also very difficult to value because they are based off other securities.
Since it’s already difficult to price the value of a share of stock, it becomes that much
more difficult to accurately price a derivative based on that stock. Moreover, because
the derivatives market is not as liquid as the stock market, and there aren’t as many
“players” in the market to close them, there are much larger bid-ask spreads.
3. Time Restrictions
Possibly the biggest reason derivatives are risky for investors is that they have a
specified contract life. After they expire, they become worthless. If your investment
bet doesn’t work out within the specified time frame, you will be faced with a 100%
loss.
4. Potential for Scams
Many people have a hard time understanding derivatives. Scam artists often use
derivatives to build complex schemes to take advantage of both amateur and
professional investors. The Bernie Madoff ponzi scheme is a good example of this.

Who Should Invest in Derivatives?

For the reasons listed above, this is a very tough market for novice investors. Therefore, it is
made up primarily of professional money managers, financial engineers, and highly-
experienced investors.
While any investor can no doubt dabble in derivatives to test things out, beginners should not
take high risks in this market given the potential dangers. As you become more savvy and
familiar with the various types of derivatives and strategies that suit your investment style,
you can start to incorporate them further into your personal investment portfolio.
With that said, it is important to note that regardless of your experience and knowledge,
derivatives should only make up a portion of your investment portfolio. Because they can be
so volatile, relying heavily on them could put you at serious financial risk.

FINANCIAL DERIVATIVES: DATA GAPS AND NEEDS

Among the most important changes in world financial markets over the past two decades has
been the emergence of a myriad of new and rediscovered financial instruments in the form of
derivative products. Financial derivatives include swaps, options, forwards, and futures for
interest rates, currencies, stocks, bonds, indexes, and commodities. Many derivative
transactions are international, involving residents of different countries, and they are often
conducted in multiple currencies. Their rapid growth can be attributed to the need of
investors and borrowers to manage risks in an environment of fluctuating exchange rates,
interest rates, and commodity prices. Adverse changes in exchange rates, for example, can
eliminate a firm's overseas profits; commodity price fluctuations can increase input prices of
production; and changes in interest rates can put pressure on a firm's financial costs.
The wave of financial deregulation, technological innovation, and competition among market
participants has further facilitated the development of derivatives. In addition, the cost-saving
features of these products and the flexibility they afford investors and borrowers have fueled
their expansion. They have been used not only for hedging, but also for trading activities.
Particularly since the early 1980s, derivatives have come to account for a significant share of
international financial transactions. Since derivative products appear in numerous forms and
are used for various purposes in financing and portfolio management strategies, they have
complicated many aspects of the accounting, regulating, and statistical reporting of financial
transactions.
Financial Derivatives Market and its Development in India
Derivatives are financial contracts whose values are derived from the value of an
underlying primary financial instrument, commodity or index, such as: interest rates,
exchange rates, commodities, and equities. Derivatives include a wide assortment of
financial contracts, including forwards, futures, swaps, and options. The International
Monetary Fund defines derivatives as "financial instruments that are linked to a specific
financial instrument or indicator or commodity and through which specific financial risks
can be traded in financial markets in their own right. The value of financial derivatives
derives from the price of an underlying item, such as asset or index. Unlike debt
securities, no principal is advanced to be repaid and no investment income accrues."
While some derivatives instruments may have very complex structures, all of them can
be divided into basic building blocks of options, forward contracts or some combination
thereof. Derivatives allow financial institutions and other participants to identify, isolate
and manage separately the market risks in financial instruments and commodities for
the purpose of hedging, speculating, arbitraging price differences and adjusting portfolio
risks.

The emergence of the market for derivatives products, most notable forwards, futures,
options and swaps can be traced back to the willingness of risk-averse economic agents
to guard themselves against uncertainties arising out of fluctuations in asset prices. By
their very nature, the financial markets can be subject to a very high degree of volatility.
Through the use of derivative products, it is possible to partially or fully transfer price
risks by locking-in asset prices. As instruments of risk management, derivatives products
generally do not influence the fluctuations in the underlying asset prices. However, by
locking-in asset prices, derivatives products minimize the impact of fluctuations in asset
prices on the profitability and cash flow situation of risk-averse investors.

Factors generally attributed as the major driving force behind growth of financial
derivatives are:

(a) Increased Volatility in asset prices in financial markets,

(b) Increased integration of national financial markets with the international markets,
(c) Marked improvement in communication facilities and sharp decline in their costs,
(d) Development of more sophisticated risk management tools, providing economic
agents a wider choice of risk management strategies, and
(e) Innovations in the derivatives markets, which optimally combine the risks and
returns over a large number of financial assets, leading to higher returns, reduced risk
as well as transaction costs as compared to individual financial assets.

Development of exchange-traded derivatives

Derivatives have probably been around for as long as people have been trading with one
another. Forward contracting dates back at least to the 12th century, and May well have
been around before then. Merchants entered into contracts with one another for future
delivery of specified amount of commodities at specified price. A primary motivation for
pre-arranging a buyer or seller for a stock of commodities in early forward contracts was
to lessen the possibility that large swings would inhibit marketing the commodity after a
harvest.

The need for a derivatives market

The derivatives market performs a number of economic functions:

1. They help in transferring risks from risk adverse people to risk oriented people
2. They help in the discovery of future as well as current prices
3. They catalyze entrepreneurial activity
4. They increase the volume traded in markets because of participation of risk adverse
people in greater numbers
5. They increase savings and investment in the long run

Types of Derivatives

Derivative contracts have several variants. The most common variants are forwards,
futures, options and swap.

Forward Contracts

A forward contract is an agreement between two parties – a buyer and a seller to

purchase or sell something at a later date at a price agreed upon today. Forward
contracts, sometimes called forward commitments, are very common in everyone life.
For example, an apartment lease is a forward commitment. By signing a one-year lease,
the tenant agrees to purchase the service – use of the apartment – each month for the
next twelve months at a predetermined rate. Like-wise, the landlord agrees to provide
the service each month for the next twelve months at the agreed-upon rate. Now
suppose that six months later the tenant finds a better apartment and decides to move
out. The forward commitment remains in effect, and the only way the tenant can get out
of the contract is to sublease the apartment. Because there is usually a market for
subleases, the lease is even more like a futures contract than a forward contract.

Any type of contractual agreement that calls for the future purchase of a good or service
at a price agreed upon today and without the right of cancellation is a forward contract.

Future Contracts

A futures contract is an agreement between two parties – a buyer and a seller – to buy
or sell something at a future date. The contact trades on a futures exchange and is
subject to a daily settlement procedure. Future contracts evolved out of forward
contracts and possess many of the same characteristics. In essence, they are like liquid
forward contracts. Unlike forward contracts, however, futures contracts trade on
organized exchanges, called future markets. For example, the buyer of a future contact,
who has the obligation to buy the good at the later date, can sell the contact in the
future market, which relieves him or her of the obligation to purchase the good.
Likewise, the seller of the futures contract, who is obligated to sell the good at the later
date, can buy the contact back in the future market, relieving him or her of the
obligation to sell the good. Future contacts also differ from forward contacts in that they
are subject to a daily settlement procedure. In the daily settlement, investors who incur
losses pay them every day to investors who make profits.

Options Contracts:

Options are of two types - calls and puts. Calls give the buyer the right but not the
obligation to buy a given quantity of the underlying asset, at a given price on or before a
given future date. Puts give the buyer the right, but not the obligation to sell a given
quantity of the underlying asset at a given price on or before a given date.

Swap

Swaps are private agreements between two parties to exchange cash flows in the future
according to a prearranged formula. They can be regarded as portfolios of forward
contracts. The two commonly used swaps are interest rate swaps and currency swaps.
Interest rate swaps: These involve swapping only the interest related cash flows
between the parties in the same currency.
Currency swaps: These entail swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency than those in
the opposite direction.

The 4 Basic Types of Derivatives

In the previous articles we discussed about what derivative contracts are and what are the
uses of such contracts? However, one important point needs to be noticed. Today, if a new
person wants to buy a derivative contract, they will be bewildered at the sheer amount of
choice that they will have at their disposal. There are hundreds or even thousands of types of
contracts that are available in the market. This may make it seem like a difficult and
confusing task to deal with derivatives. However, that is not the case. True, that there are
hundreds of variations in the market. However, these variations can all be traced back to one
of the four categories. These four categories are what we call the 4 basic types of derivative
contracts. In this article, we will list down and explain those 4 types:
Type 1: Forward Contracts
Forward contracts are the simplest form of derivatives that are available today. Also, they are
the oldest form of derivatives. A forward contract is nothing but an agreement to sell
something at a future date. The price at which this transaction will take place is decided in the
present.
However, a forward contract takes place between two counterparties. This means that the
exchange is not an intermediary to these transactions. Hence, there is an increase chance of
counterparty credit risk. Also, before the internet age, finding an interested counterparty was
a difficult proposition. Another point that needs to be noticed is that if these contracts have to
be reversed before their expiration, the terms may not be favorable since each party has one
and only option i.e. to deal with the other party. The details of the forward contracts are
privileged information for both the parties involved and they do not have any compulsion to
release this information in the public domain.
Type 2: Futures Contracts
A futures contract is very similar to a forwards contract. The similarity lies in the fact that
futures contracts also mandate the sale of commodity at a future data but at a price which is
decided in the present.
However, futures contracts are listed on the exchange. This means that the exchange is an
intermediary. Hence, these contracts are of standard nature and the agreement cannot be
modified in any way. Exchange contracts come in a pre-decided format, pre-decided sizes
and have pre-decided expirations. Also, since these contracts are traded on the exchange they
have to follow a daily settlement procedure meaning that any gains or losses realized on this
contract on a given day have to be settled on that very day. This is done to negate the
counterparty credit risk.
An important point that needs to be mentioned is that in case of a futures contract, they buyer
and seller do not enter into an agreement with one another. Rather both of them enter into an
agreement with the exchange.
Type 3: Option Contracts
The third type of derivative i.e. option is markedly different from the first two types. In the
first two types both the parties were bound by the contract to discharge a certain duty (buy or
sell) at a certain date. The options contract, on the other hand is asymmetrical. An options
contract, binds one party whereas it lets the other party decide at a later date i.e. at the
expiration of the option. So, one party has the obligation to buy or sell at a later date whereas
the other party can make a choice. Obviously the party that makes a choice has to pay a
premium for the privilege.
There are two types of options i.e. call option and put option. Call option allows you the right
but not the obligation to buy something at a later date at a given price whereas put option
gives you the right but not the obligation to sell something at a later date at a given pre
decided price. Any individual therefore has 4 options when they buy an options contract.
They can be on the long side or the short side of either the put or call option. Like futures,
options are also traded on the exchange.
Type 4: Swaps
Swaps are probably the most complicated derivatives in the market. Swaps enable the
participants to exchange their streams of cash flows. For instance, at a later date, one party
may switch an uncertain cash flow for a certain one. The most common example is swapping
a fixed interest rate for a floating one. Participants may decide to swap the interest rates or the
underlying currency as well.
Swaps enable companies to avoid foreign exchange risks amongst other risks. Swap contracts
are usually not traded on the exchange. These are private contracts which are negotiated
between two parties. Usually investment bankers act as middlemen to these contracts. Hence,
they too carry a large amount of exchange rate risks.
So, these are the 4 basic types of derivatives. Modern derivative contracts include countless
combinations of these 4 basic types and result in the creation of extremely complex contracts.
Derivatives Market in India

Derivatives markets have had a slow start in India. The first step towards introduction of
derivatives trading in India was the promulgation of the Securities Laws (Amendments)
Ordinance, 1995, which withdrew the prohibition on options in securities. The market for
derivatives, however, did not take off, as there was no regulatory framework to govern
trading of derivatives. SEBI set up a 24-member committee under the Chairmanship of
Dr. L.C. Gupta on 18th November 1996 to develop appropriate regulatory framework for
derivatives trading in India. The committee recommended that derivatives should be
declared as 'securities' so that regulatory framework applicable to trading of 'securities'
could also govern trading of securities. SEBI was given more powers and it starts
regulating the stock exchanges in a professional manner by gradually introducing
reforms in trading. Derivatives trading commenced in India in June 2000 after SEBI
granted the final approval in May 2000. SEBI permitted the derivative segments of two
stock exchanges, viz NSE and BSE, and their clearing house/corporation to commence
trading and settlement in approved derivative contracts.

Introduction of derivatives was made in a phase manner allowing investors and traders
sufficient time to get used to the new financial instruments. Index futures on CNX Nifty
and BSE Sensex were introduced during 2000. The trading in index options commenced
in June 2001 and trading in options on individual securities commenced in July 2001.
Futures contracts on individual stock were launched in November 2001. In June 2003,
SEBI/RBI approved the trading in interest rate derivatives instruments and NSE
introduced trading in futures contract on June 24, 2003 on 91 day Notional T-bills.
Derivatives contracts are traded and settled in accordance with the rules, bylaws, and
regulations of the respective exchanges and their clearing house/corporation duly
approved by SEBI and notified in the official gazette.

the participants of derivatives market – hedgers, arbitragers &

speculators
Derivatives market participants are financial intermediaries that help maintain liquidity in the
market. They also furnish depth to the market. We all are familiar with the features of
financial markets. Through financial markets banks, corporate and government raise or
deploy money to meet their requirements. The primary markets and secondary markets are
two subcategories of a financial market. In the primary market, various financial
intermediaries raise money by issuing instruments like shares, debentures bonds, etc. While
in the secondary market you can do trading in these instruments. Means you can buy and sell
these instruments issued in primary markets in the secondary market. The stock exchange like
Bombay Stocks Exchange and National Stocks Exchange are the platform for such secondary
market tradings.
The derivative market is a part of the secondary market. You can trade the future and option
contracts of any underlying shares in a derivative market. Derivative market instruments are
quite different in characteristics from instruments of other markets. These instruments
basically help to minimize any risk that may arise from holding underlying assets. Let us now
see what a derivatives market is and how it helps in minimizing the risk.

Derivatives market helps minimize risk

The origin of the word ‘Derivatives’ is from mathematics. Literally, a derivative is a variable
that derives its value from another variable. Thus, a financial derivative is a product that
derives its value from another financial product. We refer another financial product as the
underlying in derivatives context. Hence, the derivatives market has no independent
existence without an underlying commodity or asset. The price of the derivative instrument is
contingent on the value of its underlying assets. The up and down movements in the market
results in risk. And derivatives instruments help manage these risk in markets. The
derivatives market empower investors to control their risk more efficiently and permit them
to hedge or speculate on markets. Derivatives market participants use derivative instruments
like future and options to manage their risk in the market. The next section deals with such
derivatives market participants.

Participants of derivatives market

Generally, Banks, Corporates, Financial Institutions, Individuals, and Brokers are seen as
regular participants to hedge, speculate or arbitrage in the markets. The participants can be
classified into three categories based on the motives and strategies adopted.

Hedgers are the least risk lover in the derivatives market

Hedging is an act, whereby an investor seeks to protect a position or anticipated position in
the spot market. It is done by using an opposite position in derivatives. This means that if you
have a buy position, you have to create a sell position and vice-versa. The parties who
perform hedging are known as hedgers. In the process of hedging, parties such as individuals
or companies owning or planning to own a cash commodity like corn, pepper, wheat,
treasury, bonds, notes or bills etc. are concerned that the cost of the commodity may change
before either buying it in the cash market.
They want to reduce or limit the impact of such movements, which, if not covered, would
incur a loss. In such situation, the hedger achieves protection against changing prices by
purchasing or selling futures contracts of the same type and quantity. You can achieve, such
similar objectives by exercising options. In a situation when the prices of any of your
underlying stock are intended to fall you can buy put options. Similarly, in situations with
price rise, a call option is preferred.

Speculators in derivatives market provides depth to the

market
Speculators are basically traders. They enter the futures and options contract, with a view to
making the profit from the subsequent price movements. They do not have any risk to hedge.
In fact, they operate at a high level of risk in anticipation of profits. Speculation provides
liquidity in the market.
The speculators also perform a valuable economic function of feeding information. These
pieces of information are not readily available elsewhere. They also help others in analyzing
the derivatives markets.
Arbitragers as a derivatives market participants
Some traders participate in the market for obtaining risk-free profits. They do so by
simultaneously buying and selling financial instruments like stocks futures in different
markets. This process is known as ‘arbitrage’. Thus, ‘arbitrageurs’ are the person who does
such kind of trading. For example, one can always sell a stock on NSE exchange and buy
simultaneously back on BSE platform.
The arbitrageurs continuously monitor various markets. And wherever there is a chance of
arbitraging, they buy from one market and sell in the other market. In this way, they make a
riskless profit. They keep the prices of derivatives and current underlying assets closely
consistent and perform a valuable economic function.
Arbitragers and speculators perform almost a similar function since they do not have any risk
to hedge. They help in identifying inefficiencies that exist among the markets. While
arbitragers help in price discovery leading to market efficiency. Speculators help in
enhancing the liquidity in the market.
Regulatory framework of Derivatives markets in India
With the amendment in the definition of 'securities' under SC(R)A (to include derivative
contracts in the definition of securities), derivatives trading takes place under the provisions
of the Securities Contracts (Regulation) Act, 1956 and the Securities and Exchange Board of
India Act, 1992.
Dr. L.C Gupta Committee constituted by SEBI had laid down the regulatory framework for
derivative trading in India. SEBI has also framed suggestive bye-law for Derivative
Exchanges/Segments and their Clearing Corporation/House which lay's down the provisions
for trading and settlement of derivative contracts. The Rules, Bye-laws & Regulations of the
Derivative Segment of the Exchanges and their Clearing Corporation/House have to be
framed in line with the suggestive Bye-laws. SEBI has also laid the eligibility conditions for
Derivative Exchange/Segment and its Clearing Corporation/House. The eligibility conditions
have been framed to ensure that Derivative Exchange/Segment & Clearing
Corporation/House provide a transparent trading environment, safety & integrity and provide
facilities for redressal of investor grievances. Some of the important eligibility conditions are-
· Derivative trading to take place through an on-line screen based Trading System.
· The Derivatives Exchange/Segment shall have on-line surveillance capability to
monitor positions, prices, and volumes on a real time basis so as to deter market
manipulation.
· The Derivatives Exchange/ Segment should have arrangements for dissemination of
information about trades, quantities and quotes on a real time basis through atleast two
information vending networks, which are easily accessible to investors across the country.
· The Derivatives Exchange/Segment should have arbitration and investor grievances
redressal mechanism operative from all the four areas / regions of the country.
· The Derivatives Exchange/Segment should have satisfactory system of monitoring
investor complaints and preventing irregularities in trading.
· The Derivative Segment of the Exchange would have a separate Investor Protection
Fund.
· The Clearing Corporation/House shall perform full novation, i.e., the Clearing
Corporation/House shall interpose itself between both legs of every trade, becoming the legal
counterparty to both or alternatively should provide an unconditional guarantee for settlement
of all trades.
· The Clearing Corporation/House shall have the capacity to monitor the overall position
of Members across both derivatives market and the underlying securities market for those
Members who are participating in both.
· The level of initial margin on Index Futures Contracts shall be related to the risk of loss
on the position. The concept of value-at-risk shall be used in calculating required level of
initial margins. The initial margins should be large enough to cover the one-day loss that can
be encountered on the position on 99% of the days.
· The Clearing Corporation/House shall establish facilities for electronic funds transfer
(EFT) for swift movement of margin payments.
· In the event of a Member defaulting in meeting its liabilities, the Clearing
Corporation/House shall transfer client positions and assets to another solvent Member or
close-out all open positions.
· The Clearing Corporation/House should have capabilities to segregate initial margins
deposited by Clearing Members for trades on their own account and on account of his client.
The Clearing Corporation/House shall hold the clients’ margin money in trust for the client
purposes only and should not allow its diversion for any other purpose.
· The Clearing Corporation/House shall have a separate Trade Guarantee Fund for the
trades executed on Derivative Exchange / Segment.
· Presently, SEBI has permitted Derivative Trading on the Derivative Segment of BSE
and the F&O Segment of NSE.
Purposes and Criticisms of Derivative Markets
Some of the main benefits that financial derivatives bring to the market are:
  Price discovery. Futures, forwards and swaps provide valuable information about the
prices of the underlying assets. Options provide information on the price volatility of
the underlying assets.
 Market completeness. A complete market is a market in which any and all
identifiable payoffs can be obtained by trading the securities available in the market.
The financial derivatives help traders to more exactly shape the risk and return
characteristics of their portfolios, thereby increasing the welfare of traders and the
economy as a whole.
 Risk management. This refers to the process of identifying the desired level of risk,
measuring the actual level of risk, and taking actions to bring the actual level of risk
to the desired level of risk. Financial derivatives provide a powerful tool for limiting
risks that individuals and firms face in the ordinary conduct of their business. For
speculators risks associated with financial derivatives are not necessarily evil because
they provide very powerful instruments for knowledgeable traders to expose
themselves to calculated and well-understood risks in pursuit of profit.
 Market efficiency. Derivatives provide an alternative for investing in the underlying
assets. If the prices of the underlying assets are too high, investors will invest in
derivatives, thereby reducing the demand for the underlying assets. As a result, the
derivatives market will force the prices of the underlying assets back to their
appropriate levels.
 Trading efficiency. As the derivative markets are highly liquid, financial derivatives
can be bought or sold with less transaction costs than directly trading the underlying
assets. In addition, derivatives are designed to facilitate risk management, and serve
as a form of insurance. The cost of insurance must be low relative to the value of the
insured assets. Otherwise insurance would not exist.
The complexity of derivatives means that sometimes the parties that use them don't
understand them well. As a result, they are often used improperly, leading to potentially large
losses. This can explain why unknowledgeable investors tend to consider derivatives
excessively dangerous. Derivatives are also mistakenly characterized as a form of legalized
gambling. This view tends to overlook the benefits of derivatives (e.g., risk management). In
fact, derivatives make financial market work better, not worse.