The derivatives market is the financial market for derivatives, financial instruments like futures contracts or options, which are derived from other forms of assets. They are called derivatives because they derive their values from an underlying asset. These underlying assets may be of various categories like equity, bonds, commodities, etc.
An example of a derivative contract is a Dollar Forward contract. Such a contract gives the buyer the right as well as the obligation to buy dollars at some future date. The prices of the derivatives are driven by the spot prices of the underlying assets.
There are many arguments that can be made in favour of investing in derivatives. They have used as the medium of investment in countries outside of India for a long time, and in the recent past, many Indian investors have also begun to invest in the derivatives market. So what then are the benefits of investing in the derivatives market?
Derivatives provide an excellent mechanism to hedge the future price risk. Derivatives also provide an excellent mechanism to Portfolio Managers for managing the portfolio risk and to Treasury Managers for managing interest rate risk. Index futures and Forward Rate Agreement (FRA) in this process are very important.
They provide better avenues for increasing capital with the introduction of currency and interest rate swaps. Indian corporate organizations can now raise finance from the global markets at better terms than before.
Derivative instruments make the spot price discovery more reliable using different models like the normal backwardation hypothesis. These instruments can cause any merchandise opportunities to disappear and therefore would lead to better price discovery.
They also work towards increasing the depth of the financial market. Derivatives work as a risk management tool which increases the depth of the market. Investors can thus find better ways to hedge their risks against unfavourable market movements.
Derivative markets have also been known to improve the liquidity and market efficiency of the underlying markets in the countries that such markets have come about in.
Along with all of the positive aspects of investing in the derivatives market, as with all investment related options, they have their negative points.
Many investors fear that derivative instruments will unnecessarily enhance the speculation in the financial markets. This can have far reaching consequences. Most of the people are of the opinion that the Indian markets may not be efficient enough to introduce such instruments. These instruments require a well functioning and mature spot market.
Increased speculation and inefficient markets would make the spot market more volatile with the introduction of derivatives. Also as most of the derivative instruments are not exchange traded, there is a counter party default risk associated with these instruments.
Liquidity risk is also one of the major concerns that arise from the derivatives market. These all risks can however be controlled.
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