Academicians claim that derivatives offer certain economic benefits such as risk sharing, efficient allocation of capital, information gathering and price discovery. And yet, there are widely held apprehensions about their potential to destabilize financial markets. Indeed the losses suffered in the recent past by even some of the well-managed companies vindicate the statement that derivatives trading is risky. This article juxtaposes the economic benefits along with the inherent risks of derivative products and cautions that they must be traded with care to maximize benefits and mitigate risks.
Derivatives simply facilitate a more efficient allocation of economic risks. For instance, an Indian exporter can hedge the underlying exchange-risk of his dollar denominated export receipts by purchasing a currency `put' option or by selling a currency `forward' or `futures' contracts. A fund manager can hedge his stock market exposure by selling index futures contract. Similarly, a commercial bank can hedge against interest rate gap between assets and liabilities by either buying or selling interest rate swaps, as the situation demands. In this sense, the derivatives market can be compared to an insurance company that indemnifies the risks associated with the unfavorable market movements against payment of premiums.
Secondly, derivatives trading adds to the `completeness' of the market. Here `complete market' means, a market in which there is a distinctive marketable security for each and every possible outcome. It is the market where instruments which can solely or jointly, provide a cover against all the possible adverse outcomes can be innovated. As a principle, the intertemporal nature of financial decisions implies uncertainty. It is therefore essential for a market to provide a wide range of instruments to diversify risks. In this context, derivative products provide a cover against all possible future adverse outcomes, either singly or jointly. Thus, the market completeness enables individuals to achieve any desired risk allocation pattern in terms of pay-off distribution across assets. In short, it facilitates an unconstrained Pareto co-efficient allocation of risk
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