Answer to Question #190809 in Economics for shargeel khan

Question

If speculators were not present in derivatives markets, would these markets work more efficiently or less efficiently? Explain. 

Answer 1

Derivatives market

There are four groups of its participants:

Hedgers. As stated, hedging is an investment to eliminate the risk of future price changes. Derivative financial instruments effectively offset the risks with the corresponding underlying assets.

Speculators. They are engaged in the most common and at the same time very risky activities, buying or selling financial instruments or assets with the expectation that their price will change in their direction in the future.

Arbitrageurs. Individuals or legal entities who, based on their knowledge of the situation and prices in the markets, but on some of them and sell on others.

Margin traders. Margin is the collateral deposited by an investor investing in a financial instrument. Margin trading involves transactions with financial assets using borrowed funds provided by a broker.

Derivative functions

Management of risks. Since the prices of financial derivatives are linked to their underlying assets, derivatives are used to both increases and decrease the risk of owning an asset. You can mitigate your risk by buying a spot commodity and selling a futures contract or option. If the spot price (current price) falls, then the corresponding futures and options also fall in price. Then the contract can be redeemed at a lower price, which can partially offset the losses on the spot commodity.

Price forecast. The derivatives market very often follows the spot market and practically does not serve as an important source of information.

Operational benefits. Derivatives markets are more liquid than spot markets. This means lower commissions and other costs for traders.

Pros and cons of derivatives

Benefits of derivatives:

Reduce financial risks (hedging).

They provide leverage as they are often purchased on margin.

Provide more room for speculative policy.

They make it possible to make money on buying and selling at a low cost of a derivative asset.

Cons of derivatives:

Leverage can be negative if the price moves in the opposite direction from the position.

Sensitivity to changes prior to expiration, such as the cost of ownership of the underlying asset and interest rates;

Legal vulnerability of over-the-counter derivatives classified by law as bets and devoid of legal protection.

If there were no speculators on the derivatives market, the market would be more stable.