When we talk about derivatives, we mean an instrument whose value is derived from the value of one or more underlying, which can be commodities, precious metals, currency, bonds, stocks, stocks indices, etc.
The most common examples of derivative instruments are Forwards, Futures, Options and Swaps. So it means derivative instruments are those instruments that can be sold and you can gain profit out of it. However, there are quite a few benefits of selling financial instruments and it also has a few purposes.
So before we discuss about the benefits, let’s see how a derivative derives profits form. Here are a few ways derivatives can derive profits from –
1. When there are changes in the equity markets and in the interests around the world.
2. When the currency exchange rates shifts from one place to another.
3. When there is a change in the global supply and demand for commodities such as agricultural products, precious and industrial metals, and energy products such as oil and natural gas.
As it has been already mentioned above, there are quite a few benefits of these derivatives. Here are they –
1. The 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 such as the climatic conditions, political situations, debt default, refugee displacement, land reclamation and environmental health, impact supply and demand of assets and especially in the commodities in particular. And thus the current and future prices of the underlying asset on which the derivative contract is based.
2. The risk management – Derivative market is well known for its risk management capacity. So what does the risk management actually mean? This is actually a process where the level of risks are indentified and after that, there are measures taken through which the desired level of risks are indentified and then alter the former to equal the latter. This category actually falls under the category of hedging and speculation.
3. Improving the market efficiency of for the particular asset – The financial instrument or the asset you are selling would be immensely efficient in the market and this is going to happen because it is the derivative. The derivatives improve the market efficiency as the investors will sell the richer asset and buy the cheaper one until prices reach equilibrium. In this context, derivatives create market efficiency.