Subject 5. 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.

User Contributed Comments 6

You need to log in first to add your comment.
johntan1979: In his 2002 letter to Berkshire Hathaway shareholders, Warren Buffett dubbed derivative securities as "financial weapons of mass destruction."

We all know very well what happened not so much later.....
To-be-CFA: Benefits of Derivatives:
- Provide price information.
- Allow risk to be managed and shifted among market participants.
- Reduce transaction costs.
- Promote market efficiency.
irapp92: @johntan1979.. From my understanding, buffet still holds the belief that derivatives are the largest existential threat to the modern global economy, mostly due to their complexity and opaqueness on BB bank books. He seems to imply 2008 was merely a glimpse into the depth and scope of the derivatives market + the risks inherent. Great infographic put out by money.visualcapitalist.com titled "All of the Worlds Money and Markets in One Visualization"... Definitely worth checking out if you're feeling a bit apocalyptic.
jmorris: Like most things, the issue isn't derivatives, but the humans who trade them. For businesses that are exposed to short-term price fluctuation in commodities or currencies, derivatives are extremely beneficial. However, when traders artificially push prices in one direction or the other, resulting in wild swings in prices, things get dangerous. How you stop humans from being humans is a tough problem to solve though, especially considering all these things were artificially created by us in the first place.
yassine: @johntan1979 - Is a sharp knife a dangerous weapon or useful tool? It all depends how you use it.
sshetty2: Where do you draw the line between an unknowledgable investor and a knowledgeable one? And, better yet, who is actually drawing that line. Hmm, better to just use derivatives to even out a portfolio, lol.