Study Guide: CFA Level 1

Derivatives - Purposes and Benefits of Derivatives

Today's sophisticated international markets have helped foster the rapid growth in derivative instruments. In the hands of knowledgeable investors, derivatives can derive profit from:
  • Changes in interest rates and equity markets around the world
  • Currency exchange rate shifts
  • Changes in global supply and demand for commodities such as agricultural products, precious and industrial metals, and energy products such as oil and natural gas

Adding some of the wide variety of derivative instruments available to a traditional portfolio of investments can provide global diversification in financial instruments and currencies, help hedge against inflation and deflation, and generate returns that are not correlated with more traditional investments. The two most widely recognized benefits attributed to derivative instruments are price discovery and risk management.

1. Price Discovery
Futures market prices depend on a continuous flow of information from around the world and require a high degree of transparency. A broad range of factors (climatic conditions, political situations, debt default, refugee displacement, land reclamation and environmental health, for example) impact supply and demand of assets (commodities in particular) - and thus the current and future prices of the underlying asset on which the derivative contract is based. This kind of information and the way people absorb it constantly changes the price of a commodity. This process is known as price discovery.
    • With some futures markets, the underlying assets can be geographically dispersed, having many spot (or current) prices in existence. The price of the contract with the shortest time to expiration often serves as a proxy for the underlying asset.
    • Second, the price of all future contracts serve as prices that can be accepted by those who trade the contracts in lieu of facing the risk of uncertain future prices.
    • Options also aid in price discovery, not in absolute price terms, but in the way the market participants view the volatility of the markets. This is because options are a different form of hedging in that they protect investors against losses while allowing them to participate in the asset's gains.
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As we will see later, if investors think that the markets will be volatile, the prices of options contracts will increase. This concept will be explained later.

2. Risk Management
This could be the most important purpose of the derivatives market. Risk management is the process of identifying the desired level of risk, identifying the actual level of risk and altering the latter to equal the former. This process can fall into the categories of hedging and speculation.

Hedging has traditionally been defined as a strategy for reducing the risk in holding a market position while speculation referred to taking a position in the way the markets will move. Today, hedging and speculation strategies, along with derivatives, are useful tools or techniques that enable companies to more effectively manage risk.

3. They Improve Market Efficiency for the Underlying Asset
For example, investors who want exposure to the S&P 500 can buy an S&P 500 stock index fund or replicate the fund by buying S&P 500 futures and investing in risk-free bonds. Either of these methods will give them exposure to the index without the expense of purchasing all the underlying assets in the S&P 500.

If the cost of implementing these two strategies is the same, investors will be neutral as to which they choose. If there is a discrepancy between the prices, investors will sell the richer asset and buy the cheaper one until prices reach equilibrium. In this context, derivatives create market efficiency.

4. Derivatives Also Help Reduce Market Transaction Costs
Because derivatives are a form of insurance or risk management, the cost of trading in them has to be low or investors will not find it economically sound to purchase such "insurance" for their positions
Next: Criticisms of Derivatives »
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Investopedia.com

Investopedia.com
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