Economic functions of Derivative contracts.pptx

Economic functions of Derivative contracts

1. Economic functions of Derivative contracts Ramya B Assistant Professor B.com(PA) Sri Ramakrishna College of Arts and Science Coimbatore - 641 006 Tamil Nadu, India

2. Economic functions of Derivative contracts Derivative contracts perform a number of economic functions. Important functions may be outlined as below:- 1. Risk management functions 2. Price discovery function 3. Liquidity function 4. Efficiency function 5. Portfolio management function 6. Economic development function

3. 1. Risk management functions This is the primary function of derivatives. Derivatives shift the risk from the buyer of the derivative product to the seller. Thus, derivatives are very effective risk management tools. Most of the world’s 500 largest companies use derivates to lower risk. 2. P rice discovery function This refers to the ability to achieve and disseminate price information. Without price information, investors, consumers, and producers cannot make informed decisions.

4. They cannot direct their capital to efficient uses. Derivatives are exceptionally well suited for providing price information. They are the tools that assist everyone in the market place to determine value. The wider the use of derivatives, the wider the distribution of price information. 3. Liquidity function Derivatives contract improve the liquidity of the underlying instruments. They provide better avenues for raising money. They contribute sustainability to increasing the depth of the markets.

5. Derivative markets often have greater liquidity than the spot markets, this higher liquidity is at lest partly due to the smaller amount of capital required for participation in derivative markets. Since the capital required is less, more participants will operate in the market. This leads to increased volume of trade and liquidity. 4. Efficiency function Derivatives significantly increase market liquidity, as a result, transactional costs are lowered, the efficiency in doing business is increased, the cost of raising capital investment is expanded.

6. 5. Portfolio management function Derivatives help in efficient portfolio management. With a smaller fund at disposal,better diversification can be achieved. Derivatives provide much wider menu to portfolio managers who constantly seek better risk return trade off. 6. Economic development function Bright, creative, well educated people with an entrepreneurial attitude will be attracted towards the derivative markets. Derivative markets energise other to create new businesses, new products and new employment opportunities. Derivative markets help increase savings and investment in the long run.