Lesson 2 of 6 · All lessons in this module
- Benefit 1: transferring risk and creating new exposures
- Benefits 2–4: price discovery, operational and market efficiency
- Risks 1: implicit leverage and lack of transparency
- Risks 2: basis, liquidity, counterparty credit and systemic risk
- How issuers use derivatives: hedging and hedge accounting
- How investors use derivatives, and issuers versus investors
Lesson 2 of 6 · 13 min
Benefits 2–4: price discovery, operational and market efficiency
Derivative prices reveal information about expected future prices and risk, derivatives are cheaper and easier to trade than the underlying, and that ease pushes prices towards fundamental value faster.
In short
- Price discovery: futures prices give a read on where cash prices are heading (though not an unbiased forecast); option prices reveal implied volatility, the market's expected price risk.
- Operational advantages: no transport, storage or insurance of physical goods; greater liquidity; small upfront cash (margin or premium); easy short positions.
- Financing a margin deposit costs a fraction of financing a full cash purchase of the same exposure.
- Market efficiency: lower capital, lower costs and easy shorting make it cheaper to exploit mispricing, so fundamental value often shows up in derivative prices before cash prices.
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