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11.3 Purposes Of Derivative Markets

Price discovery: Futures prices provide useful information on the price of the underlying asset (the current price of the underlying asset is called the spot price). A short-term futures price is sometimes used as a proxy for the spot price.

Options prices provide information about the volatility of the underlying security.

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Risk management: An important use of derivatives is to control risk including removing certain types of risk from investment.

Market completeness: This means that all potential payoffs can be obtained by trading securities available in the market. The inclusion of derivatives in a market adds to the different risk/return combinations available.

Speculation: Speculation is taking on risk in pursuit of additional profit.

Trading efficiency: Investing in a derivative can be a more attractive alternative than investing in the underlying instrument. This might be a result of greater liquidity or lower transaction costs in the derivatives market.

Criticisms of derivative markets

  • Many of the criticisms of derivatives stem from their complexity, which leads to commentators misunderstanding their role, or investors purchasing derivatives without understanding the risks involved.
  • Derivatives are often seen as legalized gambling. This is an unfair criticism since derivatives have the benefit of making financial markets work better and provide a means for people to manage risk, whereas it is difficult to argue that gambling improves society as a whole.

An arbitrage is when it is possible to trade and generate a riskless profit, without needing to make a net investment in the security being arbitraged. This opportunity might occur if the same security was priced differently in different stock markets or derivatives were mispriced. The text assumes that there are no arbitrage opportunities (the no-arbitrage principle) since arbitrage opportunities will not exist in an efficient market.

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