Advantages and Disadvantages of Derivatives

Meaning of Derivatives

Derivatives are financial instruments used for trading in the market whose value is dependent upon one or more underlying assets. It is a security that derived its value from underlying assets such as stocks, currencies, commodities, precious metals, stock indices, etc. Derivatives represent a contract that is entered into by two or more parties.

This contract is regarding the money payments and sell/purchase of assets between the parties. There are certain conditions which are attached to this contract while entering into such as contractual obligations of parties, date of maturity, notional amount and resulting values of underlying instruments. Derivative instruments are mainly used for hedging the risk or earning profit through speculation on value of underlying security.

These instruments are either traded over the counter or via an exchange. Over-the-counter (OTC) derivatives are one which is traded privately and without any intermediary whereas exchange-traded derivatives are traded via specialized exchanges such as Bombay stock exchange. Futures, forwards, options and swaps are four main types of derivative instruments.

Advantages of Derivatives

Hedging Risk

Derivative contracts are used for hedging risk arising out of fluctuations in price movements. Value of these contracts is dependent upon the value of underlying assets.  Investor will purchase those derivative contracts whose value moves opposite to the value of security the investor owns. Therefore, losses in underlying commodities may be offset by profit in contracts of derivatives.

Determine Underlying Asset Price

Derivatives contracts helps in ascertaining the price of underlying assets. An approximation of commodity prices is known through the spot prices of future contracts. 

Provide Access to Unavailable Market or Asset

Another important advantage of derivative is that it provides access to unavailable market and assets to peoples. Individuals can acquire funds at lower or favorable rate of interest as compared to direct borrowings with the help of interest rate swaps.

Enhance Market Efficiency

Derivatives plays an efficient role in improving the financial market’s efficiency. These contracts are used for replicating the assets payoff. It enables in getting fair and correct economic value of underlying commodity as these contracts brings price corrections via arbitrage. This way market becomes price efficient and an equilibrium is attained. 

Low Transaction Cost

Trading of these instruments involves low transaction cost which is beneficial for investors. This acts as a risk management tool and a protection against price fluctuations. Cost of trading in derivatives is lower as compared to other securities like shares or debentures.

Advantages and Disadvantages of Derivatives
Advantages and Disadvantages of Derivatives

Disadvantages of Derivatives

High Risk

Derivatives contracts are exposed to high degree of risk due to high volatile price of underlying securities. Prices of these underlying securities like shares or metals keeps on changing rapidly as derivatives are mostly traded in open market. This involves a high degree of risk.

Counter Party Risk

There is a possibility of default on the part of counter-party in case of derivatives traded over the counter due to lack of due diligence process.  OTC derivatives as compared to exchange derivatives lacks a benchmark for due diligence.

Speculative Features

Derivatives are instrument which are used for speculation purpose for earning profits. Sometimes huge losses may occur due to unreasonable speculation as derivatives are of unpredictable and high risky nature.

Requires Expertise

This is one of the major drawbacks in trading of derivative instruments. Investor’s requires high knowledge and expertise for trading in these instruments as compared to other securities likes stocks and metals.