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What are the Applications of Financial Derivatives as commonly used in finance?
Solution
1.Efficiency in trading
Financial derivatives allow for free trading of risk components and that
leads to improving market efficiency. Traders can use a position in one or more financial
derivatives as a substitute for a position in the underlying instruments. In many instances, traders find financial derivatives to be a more attractive instrument than the underlying security. This is mainly because of the greater amount of liquidity in the market offered by derivatives as well as the lower transaction costs associated with trading a financial derivative as compared to the costs of trading the underlying instrument in cash market.
2.Speculation
This is not the only use, and probably not the most important use, of financial derivatives. Financial derivatives are considered to be risky. If not used properly, these can lead to financial destruction in an organization like what happened in Barings Plc. However, these instruments act as a powerful instrument for knowledgeable traders to expose themselves to calculated and well understood risks in search of a reward, that is, profit.
3.Price stabilization function
Derivative market helps to keep a stabilizing influence on spot prices by reducing the short-term fluctuations. In other words, derivative reduces both peak and depths and leads to price stabilization effect in the cash market for underlying asset.
4.Management of risk:
This is most important function of derivatives. Risk management is not about the elimination of risk rather it is about the management of risk. Financial derivatives provide a powerful tool for limiting risks that individuals and organizations face in the ordinary conduct of their businesses. It requires a thorough understanding of the basic principles that regulate the pricing of financial derivatives. Effective use of derivatives can save cost, and it can increase returns for the organizations.
5.Price discovery
Another important application of derivatives is the price discovery which means revealing information about future cash market prices through the futures market. Derivatives markets provide a mechanism by which diverse and scattered opinions of future are collected into one readily discernible number which provides a consensus of knowledgeable thinking.
Daniel Nthiwa answered the question on March 20, 2022 at 10:14
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