Advantages of Derivatives

Derivative instruments offer several potential advantages over cash market transactions, including the following:

Ability to change risk allocation, transfer risk, and manage risk

We have discussed these benefits in our introduction to derivative contracts. Some examples of ways that risk exposures can be altered using derivatives, without any cash market securities transactions, are:

• A portfolio manager can increase or decrease exposure to the risk and return of a market index.
• A manufacturer can hedge the exchange rate risk of anticipated receipts or payments.
• The issuer of a floating-rate note can change that exposure to a fixed-rate obligation.

Derivative instruments can be used to create risk exposures that are not available in cash markets. Consider the following examples of changing an existing risk profile:

• The owner of common stock can buy puts that act as a floor on the sale price of their shares, reducing the downside risk of the stock by paying the cost of the puts.
• An investor can acquire the upside potential of an asset without taking on its downside risk by buying call options.

Information discovery

Derivatives prices and trading provide information that cash market transactions do not.

• Options prices depend on many things we can observe (interest rates, price of the underlying, time to expiration, and exercise price) and one we cannot, the expected future price volatility of the underlying. We can use values of the observable variables, together with current market prices of derivatives, to estimate the future price volatility of the underlying that market participants expect.
• Futures and forwards can be used to estimate expected prices of their underlying assets.
• Interest rate futures across maturities can be used to infer expected future interest rates and even the number of central bank interest rate changes over a future period.

Operational advantages

Compared to cash markets, derivatives markets have several operational advantages. Operational advantages of derivatives include greater ease of short selling, lower transaction costs, greater potential leverage, and greater liquidity.

• Ease of short sales. Taking a short position in an asset by selling a forward or a futures contract may be easy to do. Difficulty in borrowing an asset and restrictions on short sales may make short positions in underlying assets problematic or more expensive.
• Lower transaction costs. Transaction costs can be significantly lower with commodities derivatives, where transportation, storage, and insurance add costs to transactions in physical commodities. Entering a fixed-for-floating swap to change a floating-rate exposure to fixed rate is clearly less costly than retiring a floating-rate note and issuing a fixed-rate note.
• Greater leverage. The cash required to take a position in derivatives is typically much less than for an equivalent exposure in the cash markets.
• Greater liquidity. The low cash requirement for derivatives transactions makes very large transactions easier to handle.

Improved market efficiency

Low transaction costs, greater liquidity and leverage, and ease of short sales all make it less costly to exploit securities mispricing through derivatives transactions and improve the efficiency of market prices.