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
Economy"Faces Risk (Price Volatility)."
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Derivatives Market"Mechanism to price and trade this risk."
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Result"Businesses can focus on production, not worrying about price fluction."
3. Exam Notes: Writing the Answer
Question: "Explain the economic functions of the Derivatives Market." (5 Marks)
Answering Strategy:
- Headings: Price Discovery, Risk Transfer, Liquidity.
- Explain Price Discovery: "Futures prices serve as a forecast...".
- 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! 🎯
Test Your Knowledge
Question 1 of 4
1. The process of revealing the future expected price of an asset is called: