Purposes of and controversies related to derivatives

Purposes:

• Risk allocation, transfer, and management: The derivative instruments help in hedging of risk without taking a position in the underlying instrument. The risk that an investor does not want to take can be transferred to the other party e.g.-> credit risk.
• Information discovery: The derivative markets provide the indication of the direction of the underlying. The options can tell the implied volatility of the underlying markets, and the call to put ratio can be used in identifying the sentiment of the market. If a bond is expected to be downgraded or upgraded, it is first reflected in its CDS spread.
• Operation advantages: Lower transaction costs, high leverage, more liquid markets, forward/futures instruments can be easily shorted as compared to the spot markets.
• Market efficiency: It helps in increasing the market efficiency by taking advantages of arbitrage opportunities (due to lower transaction costs and ease of shorting) which is relatively difficult in the spot markets. They help in improving the liquidity of the markets due to their ability to hedge the risks.

Criticisms:

• Speculation and gambling: Though the presence of speculators has decreased the hedging costs, but they are typically seen in an unfavorable light and are compared to It fails to recognize the fact that unlike gambling where there is no benefit to the society as a whole, the speculation provides many benefits.
• Destabilization and systematic risk: It can result in excessive speculation trading that can destabilize the markets and lead to instability in the markets. There can be large losses if the trader is caught on the opposite side and that can lead to the contagion effect across the market and thus increasecomplex in nature and difficult to understand and that can lead to huge losses for an uninformed trader.

Check your concepts:

(57.8) Which of the following derivative contracts is most likely to convey the volatility of the underlying?

(a) Futures contract
(b) Swap contract
(c) Option contract

(57.9) The presence of speculators in the derivative markets have lead to:

(a) an increase in the hedging costs
(b) a decrease in the hedging costs
(c) less liquidity

Solutions:

(57.8) Correct Answer is C: The option contract conveys the implied volatility of the underlying. The volatility of the underlying does not impact the pricing of futures and swap contracts.

(57.9) Correct Answer is B: The presence of speculators have increased the liquidity in the derivatives markets and thus led to a decrease in the hedging costs.

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