Participation of derivatives in economic functions
The derivatives market performs a number of economic functions:
First, prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well as current prices.
Second, the derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them.
Third, derivatives due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witness higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.
Fourth, speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets.
Fifth, an important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well educated people with and entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense.
Finally, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity.
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