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    of 2

    Advantages of Derivatives

    Unsurprisingly, derivatives exert a significant impact on modern finance because they


    provide numerous advantages to the financial markets:

    1. Hedging risk exposure

    Since 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.

    2. 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.

    3. 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. Therefore, the prices
    of the underlying asset and the associated derivative tend to be in equilibrium to
    avoid arbitrage opportunities.

    4. 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.

    Disadvantages of Derivatives

    Despite the benefits that derivatives bring to the financial markets, the financial
    instruments come with some significant drawbacks. The drawbacks resulted in
    disastrous consequences during the financial crisis of 2007-2008. The rapid
    devaluation of mortgage-backed securities and credit-default swaps led to the
    collapse of financial institutions and securities around the world.
    1. High risk

    The high volatility of 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.

    2. 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.

    3. Counter-party risk

    Although 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.

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