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Knowledge Center » Finance & Investment » IMPORTANCE OF DERIVATIVE TRADING

Importance of derivative trading
Define Derivates

Most experts believe that the value of the derivative markets around the world is about $1200 Trillion which is about 20 times the size of the global economy. While the risks involved are obvious (because of them being leveraged contracts), there hold several opportunities and benefits as well. Some of them include the following:

1)   Reduced risk: while trading, there are usually 3 kinds of risks
•    Credit risks : is the risk of the counterparty not meeting its obligations /making payments and thus is also called default risks
•    Market ris ks:refers to losing capital in the markets due to price fluctuations
•    Liquidity  risks: arise when there isn’t enough participation in the market
Derivatives help in controlling these risks as they don’t create new risks; they just transfer the burden of existing risks to people who are willing to take them. Companies can hedge their positions in the market by taking a position opposite to their position in the spot markets and thus control a huge amount of risk. Companies that don’t event trade on the market can control risks. For example, suppose XYZ is an Indian Airline Company. For them, their major cost is fuel which is imported. Any fluctuations in the price of the fuel could hamper their operations in a major way. To protect themselves from major swings, they can take positions in the derivatives market. They can purchase USD-INR futures as well as oil futures which would help them offset the risk. If the local currency depreciates or the price of crude goes up, they shall be protected as they will earn enough money from the derivatives market to make up for that.

2)   Reduced Costs : The costs of transacting in the derivatives is much lower than taking cash positions. The margin requirements are generally 5-10, and hence only one tenth the money is required to take a position in the derivatives market equal to the value of the cash market position

3)   Varied Options:
With derivatives, there are increased options available for individuals as well as corporations. For example, instead of taking a position in all 30 stocks in the SENSEX to ensure diversification, the company can trade SENSEX futures/options which would provide them with the same exposure without the hassle of holding so many positions

4)   Provide Liquidity: The total value of assets traded on the derivatives market is much higher than value on the spot market. This ensures that there is a buyer for every seller and every position taken in the market can be exited as easily without a loss of capital due to lack of liquidity.it gives traders the confidence of finding someone to transact with

5)   Long Term Risk: Previously it was not possible for companies to protect long term risks (10-15) years. But now, as seen in a few examples, using derivatives like swaps, companies can ensure that they protect long term risks like currency and interest rate movements and focus on managerial decisions which are the most important ones for the business
In Conclusion