Functions of Derivatives Market:
To reduce risk or eliminate risks some ways and methods are there. Risk in the capital market can be reduced by diversification or putting eggs in different basket in the words of James Tobin. However, by diversification we can reduce company specific risk or unsystematic risk. There is also risk to the business due to fire, accident, theft etc but these can be insured. But there is one risk - systematic risk or market risk which occurs due to macroeconomic fluctuations in the economy and cannot be diversified away. This is the risk which if cannot be handled properly will lead to huge losses. To reduce systematic risk derivatives products are invented in the market. These derivatives products perform certain important functions. They are:
Provide Hedging Facilities to the Economic Agent: The futures market provides hedging facilities to the economic agent. Hedging can be obtained by taking opposite position in the futures market. Thus, one can use futures market to reduce or eliminate price risk.
Price Discovery: This market performs a very important economic function of price discovery. Prices in a futures market reflect the perceptions of market players about future and take the prices of the underlying to the perceived level. The prices of futures contracts converged with prices of underlying asset on the expiration date. Thus, futures market help in price discovery of not only future but also current prices in the cash market.
Augment Volume of Cash Market: The underlying cash market volume will witness a higher trading volume in presence of an efficient futures market. The simple reason is participation by more market players who earlier due to lack of these risk management tools kept themselves out of market will now trade in the cash market and augment the trading volume.
Shift Speculating Trading to Futures Market: In the presence of futures market, speculation shift from cash market to futures market which is more controlled and properly regulated by concerned authority. In the absence of futures market, these rouge traders trade in the cash market and monitoring, margining and surveillance become extremely difficult in such an environment.