The derivates are financial products that have exploded into public consciousness not that long ago. Many people invest in them nowadays for the purpose of minimizing investment risks and for reaching higher levels of profits. But what are some of the advantages of investing in this financial product? And are there any disadvantages to this? Well, by reading the rest of this article you will find more about the pros and cons of the financial derivatives.
Pros of derivatives
The first main benefit of the existence of derivatives comes in the fact that they enable price discovery. The fact is that the derivatives encourage anyone that’s focused on speculation, hedging, and arbitrage to increase the competition of the market. There are many people that follow the market very closely and they are “trigger happy” when it comes to trading for any reason whatsoever. If there is any change of the price, then this attracts the attention of the speculators on the market. And this participation of those involved in the market will make sure that there will be a fair price set in place. In the end, the result is a lot more efficient and effective discovery of the price of assets.
The derivatives are also useful for risk management. In fact, this is often stated as one of the most important purposes of the derivatives market. The art and science of risk management boil down to the following: you first need to identify the current level of risk, then you need to identify the desired level of risk, and finally, you need to put the first category nearer to the second. There are terms for this process – hedging and speculation. Hedging is a strategy that you can use in order to reduce the risk when it comes to holding a particular market position. Speculation, on the other hand, means that you’ll use strategies in order to take a new position on the market according to its projected movements. Both the speculation and the hedging strategies, alongside the derivatives, are very useful tools for the purpose of risk management.
The market is more “complete” when there are derivatives involved. The completeness of a market is more of a theoretical concept, to be fair – it’s not seen in practice. However, the derivative financial instruments help create a more stable market in the sense that they provide a safety net against potentially adverse outcomes.
The fact is that the derivatives also decrease the overall costs. Since there are many participants in the market, it remains that there will be low transactional costs. However, there are still ways in which you can ruin things with the derivatives. This is why it’s important to be prudent with their use.
Cons of derivatives
The derivatives raise the volatility of the markets.They do this by leading to speculation due to the fact that there are a large number of investors that make small investments.
The derivatives can also lead to a higher number of bankruptcies. The participants on the derivatives market often take a position that doesn’t really match their real financial capabilities. And this can lead to bankruptcy down the road.
It takes a lot of regulation for the derivatives market to function well. The high incidence of speculation and bankruptcy makes the need for regulation paramount.
While it’s true that the derivative financial instruments have their good sides, they also have their bad sides as well. So, it’s up to you to determine whether they offer the right opportunity for you in terms of making investments.