The value of the derivatives is linked to the value of the underlying asset, the contracts are primarily used for hedging risks.
For example, an investor may purchase a derivative contract whose value moves in the opposite direction to the value of an asset the investor owns.
In this way, profits in the derivative contract may offset losses in the underlying asset.
Underlying asset price determination
Derivates are frequently used to determine the price of the underlying asset. For example, the spot prices of the futures can serve as an approximation of a commodity price.Market efficiency
It is considered that derivatives increase the efficiency of financial markets. By using derivative contracts, one can replicate the payoff of the assets.
Access to unavailable assets or markets
Derivatives can help organizations get access to otherwise unavailable assets or markets.
By employing interest rate swaps, a company may obtain a more favorable interest rate relative to interest rates available from direct borrowing.
Limitations of Derivatives
High risk
The high volatility of the derivatives exposes them to potentially huge losses.
The sophisticated design of the contracts makes the valuation extremely complicated or even impossible. Thus, they bear a high inherent risk.
Speculative features
Derivatives are widely regarded as a tool of speculation.
Due to the extremely risky nature of derivatives and their unpredictable behavior, unreasonable speculation may lead to huge losses.
Counter-party risk
Derivatives traded on the exchanges generally go through a thorough due diligence process, some of the contracts traded over-the-counter do not include a benchmark for due diligence. Thus, there is a possibility of counter-party default.
Requires expertise
In case of derivatives it is very difficult to sustain in the market without expert knowledge in the field.
