Question

1. What are the economic functions of derivative markets? Discuss

Answer 1

The economic functions of derivative markets are :

• Price discovery - The fair price of the underlying asset is discovered through pricing of the futures or other derivatives. Information dissemination and determination of fair value of a security is made faster, more accurate and more efficient through the use of derivatives.
• Risk management - Derivatives facilitate transfer of risk between different parties. Hence, they serve the function of risk management. For example, hedging is risk management strategy undertaken using derivatives.
• Transaction efficiency - The use of derivatives increases volumes in the cash market as well. As a result of the increased liquidity, transaction costs are lowered and transactions can be executed more effectively.