Speculation, Risk Management, Trading Efficiency

Speculation

Financial derivatives have a reputation for being risky. Without doubt, these instruments can prove tremendously risky in the hands of uninformed traders.

However, the risks associated with financial derivatives are not necessarily evil, because they provide very powerful instruments for knowledgeable traders to expose themselves to calculated and well understood risks in pursuit of profit.

Risk Management

While financial derivatives are undeniably risky in some applications, they also provide a powerful tool for limiting risks that the individuals and firms face in the ordinary conduct of their business. For example, a corporation that is planning to issue bonds faces considerable interest rate risk. If interest rates rise before the bond is issued, the firm will have to pay considerably more over the life of the bond. As we will see, such a firm could use interest rate derivatives to control its exposure to this
risk. Similarly, a pension fund with widely diversified holdings in the stock market faces considerable risk from general fluctuations in stock prices. The pension fund manager could use options on a stock index to reduce or virtually eliminate that risk exposure.

Trading Efficiency

In many applications, traders can use a position in one or more financial derivatives as a substitute for a position in one or more fundamental underlying instruments. For example, we will see that an options position can mimic the profit or loss performance of an underlying stock index. In many instances, traders find financial instruments to be a more attractive instrument than the fundamental underlying security. Often the transactions costs associated with trading a financial derivative are substantially lower than the costs of trading the underlying instrument. In other situations, financial
derivatives might be more attractive than the underlying securities because of greater liquidity in the market for financial derivatives.