Why Derivatives are important?
Derivative is best used as risk management tool by which you can transfer the risk associated with the underlying asset to the party who is willing to take that risk. To simplify the risk term, it has been divided into three parts:
Credit Risk: Credit risk arises when any of the parties fail to fulfil the obligation under the agreement. Such an event is called a default. It is also known as 'default risk'.
Liquidity Risk: Liquidity risk is financial risk that arises due to uncertain cash crunch. An institution might lose liquidity if its credit rating falls, it experiences sudden unexpected cash outflows, or some other event causes counter-parties to avoid trading with or lending to the institution.
Market Risk: Fluctuation in the prices of the underlying asset contributes to market risk. Market risk comprises of four risk factors: Equity risk, Interest rate risk, Currency risk and Commodity risk.
In general, risk varies from sector to sector.
For example, Banks use derivatives to hedge against risks that may affect their operations and earnings including interest rate risk, market risk, foreign exchange risk and counter-party risk.
Farmers use derivatives to lock the price of their crops in order to protect their harvest, so they are exposed to price risk.
The importance of derivatives is increasing day by days because of high volatility in the market.
Participants of Derivatives Market:
Hedgers - Hedgers are the end users or producers of the particular asset or commodity who hedge against the price rise/fall risk.
Speculators - Speculators are the risk takers who want to benefit from the risk they take.
Arbitrageurs - Arbitrageurs usually earn profit by trading in two different markets simultaneously or two instruments related to each other.
Derivatives are risky instruments
Derivatives help to improve market efficiencies i.e. by reducing the risk for farmers, oil companies, interest rate risk for banks, etc. But they can turn out to be the cause of the massive destruction in economy. They work as a dependent instrument so if one of the underlying variables goes bankrupt that will lead to fall of whole chain which in turn may wipe out entire financial system.