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Economic function of the derivative marketSome of the salient economic functions of the derivative market include:
1.Prices in a structured derivative market not only replicate the discernment of the market participants about the future but also lead the prices of underlying to the professed future level. On the expiration of the derivative contract, the prices of derivatives congregate with the prices of the underlying. Therefore, derivatives are essential tools to determine both current and future prices.
2.The derivatives market relocates risk from the people who prefer risk aversion to the people who have an appetite for risk.
3.The intrinsic nature of derivatives market associates them to the underlying Spot market. Due to derivatives there is a considerable increase in trade volumes of the underlying Spot market. The dominant factor behind such an escalation is increased participation by additional players who would not have otherwise participated due to absence of any procedure to transfer risk.
4.As supervision, reconnaissance of the activities of various participants becomes tremendously difficult in assorted markets; the establishment of an organized form of market becomes all the more imperative. Therefore, in the presence of an organized derivatives market, speculation can be controlled, resulting in a more meticulous environment.
5.A significant accompanying benefit which is a consequence of derivatives trading is that it acts as a facilitator for new Entrepreneurs. The derivatives market has a history of alluring many optimistic, imaginative and well educated people with an entrepreneurial outlook, the benefits of which are colossal.
In a nutshell, there is a substantial increase in savings and investment in the long run due to augmented activities by derivative Market participant.[18]
[edit] Valuation
Total world derivatives from 1998–2007[19] compared to total world wealth in the year 2000[20][edit] Market and arbitrage-free pricesTwo common measures of value are:
Market price, i.e., the price at which traders are willing to buy or sell the contract;
Arbitrage-free price, meaning that no risk-free profits can be made by trading in these contracts; see rational pricing.
[edit] Determining the market priceFor exchange-traded derivatives, market price is usually transparent, making it difficult to automatically broadcast prices. In particular with OTC contracts, there is no central exchange to collate and disseminate prices.
[edit] Determining the arbitrage-free priceSee List of finance topics# Derivatives pricing.
The arbitrage-free price for a derivatives contract can be complex, and there are many different variables to consider. Arbitrage-free pricing is a central topic of financial mathematics. For futures/forwards the arbitrage free price is relatively straightforward, involving the price of the underlying together with the cost of carry (income received less interest costs), although there can be complexities.
However, for options and more complex derivatives, pricing involves developing a complex pricing model: understanding the stochastic process of the price of the underlying asset is often crucial.
