The meaning of the word ‘derivative’ is ‘derived’. A financial derivative can be defined as a financial security or instrument whose purpose or value is derived entirely from the value of the underlying asset or group of assets. The value of derivatives is based on the expected future price movement of the respective underlying asset. Underlying assets can be stocks or securities, commodities, bullion, currencies, bonds, interest rates, market index etc.
Financial derivatives have multiple benefits and addresses specific needs in the financial markets. Derivatives stand as a contract between two parties where the value of derivatives is determined by various factors like price, interest rate, exchange rate, and other factors related to the underlying assets.
Financial derivatives play a crucial role in the modern financial markets. Such financial instruments provides flexibility, maintains liquidity, manage and mitigate risks and provides investment opportunities.
Characteristics\Features of Financial Derivatives
- Financial Derivatives are the financial contracts between two parties.
- As name suggests, derivatives derive the value from the underlying asset or group of assets.
- It has specified obligation as per the contract which means there are parties involved with specified conditions.
- Derivatives facilitate price discovery and contribute to market efficiency.
- Financial Derivatives are carried off-balance sheets.
- Trading of underlying assets is not involved.
- Financial Derivatives are mostly secondary market instruments.
- Financial Derivatives are exposed to risks such as operational, counter party and legal.
- Derivatives also carry risk due to their leverage, market volatility, and complexity.
Uses of Financial Derivatives
- Financial Derivatives are used as Risk Aversion tools. Derivatives manage to averse risks through various strategies like hedging, arbitraging, spreading etc. Derivatives are used in highly volatile financial market conditions.
- Financial Derivatives for prediction of future prices. Derivatives serve as a barometer of future trends in prices for the security and hence help in discovery of new prices in the spot and future market.
- Financial derivatives enhance liquidity. Derivatives trading is basically based on margin trading hence a large number of traders, speculators, arbitrageurs are operating in the derivative market. Such tradings enhance liquidity and reduce transaction cost for underlying assets.
- Derivative is an investing instrument hence assisting investors while making investment decisions. Derivatives provide alternatives for the investors, traders and fund managers for asset allocation.
- Financial derivatives assist in financial market growth. Derivative market allows investing grounds to different market operators such as speculators, hedgers, traders and arbitrageurs based on the preferred risks. This leads to an increase in trading volume in the country.
Functions of Derivatives Market
- Price Discovery: Derivatives assist in defining prices of underlying assets and future spot rates for the commodity.
- Transfer of risks: Derivative is a contractual investment tools hence, transfer the risk from one party to another i.e. buyer to the seller
- Maintaining liquidity from derivative association with the cash market.
- Check on Speculation: Derivative helps in hedging the risk against unfavorable price movements of assets with the help of future and forward contracts.
- Encourage young investors and entrepreneurs.
- Motivates and increases savings and investments.