Main Benefits of Derivatives

Derivatives have several benefits but the main benefits are as follows:

1. Risk Management: Till now, we have come to know that derivatives are a powerful tool to manage and mitigate financial risk. They allow investors to hedge against volatile price fluctuations in assets, such as commodities, currencies, stocks, interest rates, or indices. This risk management aspect of derivatives is essential for stabilizing cash flows and protecting portfolios from uncertain market fluctuations.

2. Market efficiency and Price discovery: In a derivative market, the individuals involved in these agreements, predict the market prices and agree to future asset prices. This factor contributes to the price discovery aspect of derivatives. With the different derivatives contracts, participants express their views on where the prices would head (either bull or bear). This pricing factor benefits investors, businesses, and policymakers, making the market more efficient. New and enhanced information regarding the asset prices, makes the markets more responsive towards dynamic economic conditions.

3. Enhanced Portfolio Management and Speculation: Diversification and enhancement of portfolio returns can happen using the derivatives. As these are an advanced form of financial instruments, investors can use sophisticated investment strategies to achieve a more balanced and diversified portfolio. Further, certain speculated profits can be generated by the anticipated market movements without the requirement for actual investment, although certain risk is associated with it.

Derivatives are a form of special financial instrument where the value of these instruments is derived from an underlying asset or an index. As the name goes, derivatives are linked to some form of financial instrument, indicator, or commodity. Some commonly used assets include stocks, bonds, commodities, currencies, and market indices. Initially, these underlying assets are created using any individual security or a combination of securities. As the value of these securities changes, the value of the derivatives also keeps changing. Derivatives are those complex instruments used in trading risk in the financial markets by either hedging, speculating, or arbitraging. Derivatives form the basic concept under consideration in financial engineering. The primary purpose of derivative contracts is to generate profit by speculating the future value of the underlying asset.

Geeky Takeaways:

• Derivatives are financial contracts where the value is determined based on the underlying stocks, bonds, commodities, or certain market indices. In simple words, predicting and agreeing to a future value of an underlying asset.
• These financial contracts are used by hedgers, speculators, arbitrageurs, and margin traders for risk management, hedging, speculation, and arbitrage among different markets.
• Derivatives are traded in two platforms either via over-the-counter (OTC) trading or via a standardized exchange.
• These contracts can take either simple or complicated forms of options, futures, forwards, swaps, or warrants.