Derivatives are contract agreements enforceable at a specified future date and whose value wholly depends on the value of the underlying asset. This means that a derivative cannot have an independent value from one of the underlying assets. The underlying asset may be bonds, stocks, cash, intellectual property, or receivables. Derivative markets are the financial markets where buyers and sellers offer derivatives trade. Derivative markets serve various financial and economic purposes as explained below.
Markets for derivatives are important in determining the price of the underlying asset that is used in the determination of the value of the derivative. In these markets, the value of the derivative with the shortest time to expiration is considered to be the value of the underlying asset. The prices of all futures contracts are considered to be the prices that traders of derivatives are willing to take after they have factored in the risk involved in holding these derivatives to the future. Forward contracts and swaps are also useful in determining the price of the underlying asset by substituting the locked-in price for the uncertainty of future spot prices. Options also help in the pricing of underlying assets as they reveal the volatility of the particular asset which is a key factor to consider when making the pricing decision.
Derivative markets are also important in risk management. These markets identify the desired level of risk and the actual level of risk. The actual level of risk is altered so that it equals the desired risk level, a concept known as hedging. Hedging may also occur when two companies come together with an aim of reducing the risk involved in a particular aspect of the market. For example, a petroleum company may enter into a derivative contract with an airline company so as to avoid the uncertainty of future petroleum prices by locking in a particular price for the fuel.
Derivative markets also help in improving the market efficiency of the underlying asset. Derivative transactions are characterized by very low transaction costs. This is because they are meant to act as insurance against risk and therefore, they have to be cheap relative to the price of the underlying asset. Their low costs improve the market efficiency. Efficient markets are fair and competitive as they do not allow one party to gain an unfair advantage over the other party, thereby promoting orderliness in the financial markets.
There exists a definite positive correlation between the derivative markets and the underlying assets markets. The value of the underlying asset wholly determines the value of the derivative. If the prices of the underlying assets increase, the value of the derivative will also increase, and therefore both of them will have a similar effect in the market, a reduction in demand. The reverse is true for price reduction of the underlying asset because it will cause a price reduction of the derivative and thereby causing an increase in demand for the two.