Economic functions of the derivatives market

In spite of the fear and criticism with which the derivative markets are commonly looked at, these markets perform a number of economic functions.

1. Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well as current prices.

2. The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them.

3. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses’ higher trade volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.

4. Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kinds of mixed markets.

5. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense.

In a nut shell, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity.

According to survey conducted in India regarding the sub brokers’ opinion on the impact of derivatives market on financial market, the result obtained is given as under.

Derivative securities have penetrated the Indian stock market and it emerged that investors are using these securities for different purposes, namely, risk management, profit enhancement, speculation and arbitrage. High net worth individuals and proprietary traders account for a large proportion of broker turnover. Interestingly, some retail participation was also witnessed despite the fact that these securities are considered largely beyond the reach of retail investors (because of complexity and relatively high initial investment). Based on the survey results, the authors identified some important policy issues such as the need to bring in more institutional participation to make the derivative market in India more efficient and to bring it in line with the best practices. Further, there is a need to popularize option instruments because they may prove to be a useful medium for enhancing retail participation in the derivative market.