1)Price discovery
2) Risk transfer
Price discovery
Forward and future market are an important source of information about prices, Future market are considered a primary means for determing the spot price an aseets must exist for many assest spot market large and fragmented within each assets class there are many variteies and quality grades
The future matket assembles that information into a type of conseus reflective the spot price of the particular assest on which the future contract is based.
Derivative market price also contain information but it may be harder to extract that information from the spot market than from the future market.In all cases future market is more active information taken from it is often considered more reliable than is market information .
Future market more active information taken from it is often considered more reliable than is spot market information, future and forward market are said to provide price discovery.
Following factor affecting derivative market
1) Demand and supply
2) Expected future price of the underlying assets
3) Inerest rate
4) Time to expiry
5) Volatility
6) Market information and expectation
Risk. Transfer
Risk transfer is one of the main purpose of the derivative market. This is the primary function of derivative market which is also known as hedging price insurance risk shifting provide a vechicle through which the traders or participants can hedge their risks or protect themsleves from the advesre price movements in the underlying assets in which thy deal for example a farmer bears the risk at the planting time associated with the uncertain harvest price his wheat will command.
He may use the future market hedge risk by selling a future for example
The risk at the planting time associated with uncertain harvest price his wheat will coomand.
He may use the future market to hedge this risk by selling contract for instance if he is expected to produce 1000 tons of wheat in next six month he could estblish a price for that quantity by selling to wheat future contracts each being 100 tons.
In this way by selling these future contract the farmer intend to establish a price today that will be harvasted in the futures.