Relevant to the following CISI qualifications: ICWIM, ICAWM, Derivatives, IISI
Derivatives markets attract three main types of participants: hedgers, speculators, and arbitrageurs. Hedgers reduce the risk that they face in terms of asset prices by using futures or options markets. Speculators focus on future price movements, for which futures and options contracts provide them with extra leverage. Such investors speculate on potential gains and losses and help to make the market more liquid.
Arbitrageurs, on the other hand, take advantage of price differences in different markets. For example, they use the discrepancy between cash prices and future prices to make a profit.
The derivatives market can be seen as providing a number of economic benefits. Being speculative in nature, it provides the investor with a perception of the market not only in terms of current prices, but also in terms of the future. A further function is hat derivatives markets transfer risks from those who have no appetite for them to those who do. Finally, the underlying cash market enjoys higher trading volumes from more players as a result of risk mitigation.
• The derivatives market is a thoroughly exciting one for certain types of investor. It attracts creative, educated, vibrant, and intelligent investors who make optimal use of the opportunities offered and transfer their enthusiasm to new entrants as well. This perpetuates the entrepreneurial spirit within the economy, and not only creates better and new products but also has a positive effect on the job market.
• Importantly, derivatives markets can be extremely beneficial for both individuals and the overall economy of a country. Entrepreneurial players are energized to create new businesses, products, and concomitant employment opportunities from the profits they make from the derivatives markets. In addition, derivatives markets then also increase savings and long-term investment through the risk-transferring function. In this way, participants in the market can expand the volume of their activity as a result of the wide variety of choices available.
- The main disadvantage of the derivatives markets arises from the lack of thorough investigation into how to use the risk transfer factor. This can result in difficulty when trying to margin transactions, or to monitor various participants’ activities and tailor one’s own activity accordingly.
- A lack of thorough research and sound investment may lead to investment losses for which the investor is not prepared. The risk transfer factor therefore needs to be applied in a targeted way in order to ensure that the investor does not take unnecessary risks.
- Several risks may be involved for those who are not thoroughly familiar with speculative markets. Even though risks can be transferred, remember that the derivatives market operates on a paradigm of uncertainty. An investor who is not comfortable with uncertainty in investment might be more comfortable taking on a different type of investment structure.
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