Why do investors prefer derivatives over underlying assets?

A ‘derivative’ is a financial contract or a security with a price. Derivative contracts come in many different forms, such as forwards, futures, options, and swaps.

A ‘derivative’ is a financial contract or a security with a price. The value of a derivative contract is determined by the value of the underlying asset. Metals (gold, silver, aluminium, zinc), energy resources (oil, coal, electricity, natural gas), agricultural commodities (wheat, sugar, coffee, cotton), and financial assets are examples of underlying assets.  

In the case of gold futures, for example, the buyer agrees to accept delivery from the seller of a particular quantity of gold at a predetermined price on a predetermined date. Gold futures are standardised exchange-traded contracts.

Investors prefer derivatives over an underlying asset as they facilitate price discovery, strengthen the underlying asset's liquidity, and work effectively as a hedging tool. Also, the transaction cost is less compared to the spot market.  

Derivative contracts come in many different forms, such as forwards, futures, options, and swaps.  

• Forwards - A forward contract is an agreement between two parties to purchase or sell an underlying asset at a pre-decided price and at a future date. These customised contracts are referred to as ‘over-the-counter’ (OTC) contracts. A counterparty risk occurs because another party may breach an obligation.  
• Futures - Similar to forward contracts, but here, the key distinction is that the transaction is formal and conducted through an exchange. Futures are hence, forward contracts, which are exchange-traded.  
• Options - Both parties are not constrained by the law in option contracts because the buyer has the right but not the obligation to exercise it. Option buyer will only exercise his option when the circumstances are advantageous to him.  
• Swaps - It is an agreement to trade future cash flows. Swaps, which are sets of forward contracts, assist participants in managing the risk posed by fluctuating interest rates, currency exchange rates, etc.