Derivatives perform a variety of functions in banking, some of which are:
- Hedging: Derivatives are primarily used for hedging purposes. They enable businesses to protect themselves against price fluctuations in the underlying asset. For instance, a company can use a futures contract to lock in a price for a commodity it plans to purchase in the future. This helps the company to mitigate the risk of price fluctuations.
- Price Discovery: Derivatives also help in price discovery by enabling participants to express their views on the future direction of prices. Market participants use futures, options, and other derivatives to buy or sell an asset at a predetermined price in the future. The prices of these derivatives provide valuable information about the expected future price of the underlying asset.
- Risk Transfer: Derivatives facilitate the transfer of risk from one party to another. For instance, an investor who holds a bond with a fixed interest rate may use an interest rate swap to transfer the interest rate risk to another party.
- Leverage: Derivatives enable market participants to take leveraged positions in assets. With a small initial investment, investors can control a large position in the underlying asset. This magnifies the potential returns but also increases the risk.
- Arbitrage: Derivatives enable participants to exploit pricing inefficiencies between different markets. For instance, if the futures price of an asset is higher than its spot price, an arbitrageur may buy the asset in the spot market and sell it in the futures market to earn a risk-free profit.
- Speculation: Derivatives also provide an opportunity for investors to speculate on the future direction of prices. Speculators take positions in derivatives to make profits from anticipated price movements in the underlying asset.
Overall, derivatives perform crucial functions in banking, enabling market participants to manage their risks, discover prices, transfer risks, take leveraged positions, and make profits through arbitrage and speculation.