Functions of Derivatives Market – Liquidity & Price Stability

Why does the Government allow this "Gambling den"? Because it serves vital economic functions.

1. Key Functions

A. Price Discovery

• Futures prices tell us what the market expects the price to be next month.
• Example: If Gold Spot is 50k and Gold Futures is 52k, the market expects prices to rise. This info helps miners plan production.

B. Risk Transfer

• It transfers risk from those who cannot bear it (Hedgers) to those who willing to bear it (Speculators).

C. Enhanced Liquidity

• Speculators trade huge volumes. This means you can enter/exit positions instantly with low impact cost.

2. Diagram: The Economic Engine

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3. Exam Notes: Writing the Answer

Question: "Explain the economic functions of the Derivatives Market." (5 Marks)

Answering Strategy:

1. Headings: Price Discovery, Risk Transfer, Liquidity.
2. Explain Price Discovery: "Futures prices serve as a forecast...".
3. Volatility: Mention that it stabilizes prices by absorbing shocks.

Summary

• Barometer: The derivatives market acts as a barometer for the future health of the economy.
• Efficiency: It makes markets efficient (arbitrageurs ensure prices are correct).

Quiz Time! 🎯

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