Derivative Benefits

Some of the main benefits that financial derivatives bring to the market are:

• Risk allocation, transfer, and 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.

• 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.

• 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.

• 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.

• 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.

Derivative Risks

Derivative instruments can involve risks such as a high degree of implicit leverage and less transparency in some cases than cash instruments, as well as basis, liquidity, and counterparty credit risks. 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. Excessive risk taking in the past by market participants through the use of derivatives has contributed to market destabilization and system risk.

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.