Economic functions of Derivative contracts

1. Economic functions of
Derivative contracts
Ramya B
Assistant Professor
B.com(PA)
Sri Ramakrishna College of Arts and Science
Coimbatore - 641 006
Tamil Nadu, India

2. Economic functions of Derivative contracts
Derivative contracts perform a number of economic functions.
Important functions may be outlined as below:-
1. Risk management functions
2. Price discovery function
3. Liquidity function
4. Efficiency function
5. Portfolio management function
6. Economic development function

3. 1. Risk management functions
This is the primary function of derivatives. Derivatives shift the risk from
the buyer of the derivative product to the seller. Thus, derivatives are very
effective risk management tools. Most of the world’s 500 largest companies use
derivates to lower risk.
2. Price discovery function
This refers to the ability to achieve and disseminate price information.
Without price information, investors, consumers, and producers cannot make
informed decisions.

4. They cannot direct their capital to efficient uses. Derivatives are
exceptionally well suited for providing price information. They are the
tools that assist everyone in the market place to determine value. The wider
the use of derivatives, the wider the distribution of price information.
3. Liquidity function
Derivatives contract improve the liquidity of the underlying instruments.
They provide better avenues for raising money. They contribute
sustainability to increasing the depth of the markets.

5. Derivative markets often have greater liquidity than the spot markets,
this higher liquidity is at lest partly due to the smaller amount of capital
required for participation in derivative markets. Since the capital
required is less, more participants will operate in the market. This leads
to increased volume of trade and liquidity.
4. Efficiency function
Derivatives significantly increase market liquidity, as a result,
transactional costs are lowered, the efficiency in doing business is
increased, the cost of raising capital investment is expanded.

6. 5. Portfolio management function
Derivatives help in efficient portfolio management. With a smaller fund at
disposal,better diversification can be achieved. Derivatives provide much wider
menu to portfolio managers who constantly seek better risk return trade off.
6. Economic development function
Bright, creative, well educated people with an entrepreneurial attitude will
be attracted towards the derivative markets. Derivative markets energise other to
create new businesses, new products and new employment opportunities.
Derivative markets help increase savings and investment in the long run.