Question

Can you give reasons to use derivatives and was there any role of these in recent financial crisis? Explain with appropriate examples.

Answer 1

Derivatives are basically the instruments which derives their values from the underlying assets. There are different types of derivatives. Forwards, futures, options and swaps are the types of derivatives.

Reasons to use derivatives

1) It is not possible to physically trade the assets or securities. Hence, the concept of derivatives play an important role to provide the liquidity in the market even though there is no physical transfer taking place. For example, where the Gold cannot be traded in the market, the derivatives contract helps to increase the wealth.

2) It is the most important and beneficial contract since the profits will be very high.

3) Another important reason for using these derivatives is the fixation of price for the underlying asset. The price of derivatives will be fixed based on the price of underlying assets.

4) Basically the derivatives transfer the risk from risk averse people to risk seekers. The people who cannot bear risk transfer the risk by entering into appropriate strategies with risk seeking people.

5) The arbitrage opportunities are available in case of derivatives since the profits can be made through price differences across different markets. Foe example, if the price of gold is $25 in one market and $28 in another, the person seeking the arbitrage takes advantage by buying at the lowest price and immediately squaring off the position in market where the price is high.