Applications of Financial Derivatives

Applications of Financial Derivatives

Financial Derivatives and indeed options - have attained their overwhelming popularity and rapid growth for a variety of reasons. The retail makret makes up the largest percentage of the options market. The retail market includes individuals, private businesses and financial institutions that must trade through an Accredited Derivatives Advisor. This section briefly introduces some of the main benefits that financial derivatives bring to the market.

Market Completeness

In the theory of finance, a complete market is a market in which any and all identifiable payoffs can be obtained by trading the securities available in the market.

For example, a complete market would allow a trader to purchase a security or set of securities that would pay off if and only if the S&P 500 Index rose by 49 to 50 points over the next month. It is quite difficult to trade any combination of stocks and bonds that will pay off in this circumstance and no other. If the financial instruments in the market place were not sufficiently rich and diverse to permit such speculation, the market would be deemed incomplete.

From this definition of market completeness, we see that a complete market is an idealization. Nonetheless, completeness is a desirable characteristic of a financial market, because it can be shown that access to a complete market increases the welfare of the agents in the economy. Even if an actual market can never be truly complete, the more closely the market approaches completeness, the better off are the economic agents in the economy. Options and other financial derivatives play a valuable role in financial markets because they help move the market closer to completeness.