WHY IS THERE A DERIVATIVE MARKET?
Why does someone take a long or short position in the derivative contract rather than buying and selling on the spot? The answer to this question, in fact, is the answer to the question: why does the derivative market exist?
First, a derivative contract allows you to delay the purchase or sale of an underlying asset. Rather than buying on the spot, you can buy on some specified future date depending on your expectations about the price movements. If you expect the price to go down in the future, enter into a contract to buy later. You enter into a contract when you expect the price to go up.
Second, when you enter into a derivative contract, you do not pay anything at the initiation of the contract. However, for some contracts like options, you must pay upfront to enter into contracts; but that is far cheaper than the underlying asset (more on options later).
Third, you can either limit or eliminate the downside risk or take advantage of the upside potential, or both at the same time.
Fourth, derivatives make it possible to transfer risk. The underlying of a derivative contract bears several risks. The shares of a firm are associated with the risk of prices going up or down (price risk). A derivative on stock transfers the risk from the seller to the buyer or the seller to the buyer. A bond bears with it risks associated with the interest rate, credit, or currency (if the bond is issued in a different currency than the domestic currency). A derivative instrument written on a bond transfers interest rate risks (interest rate derivatives) or credit risk (credit default swap).
Transferring risk leads to hedging, which is one of the most important aspects of derivatives. If you currently hold 100 shares of Apple Inc., your concern is the risk of prices going down. To offset the risk, you can enter into a derivative contract written on Apple Inc. stock to sell the shares at a price that ensures profits. Here you lock in some prize or profit in the future. By holding the shares, you are faced with some risk exposure. This risk exposure is offset by entering into the derivative contract. If you do not hold any Apple Inc. shares, you don't have any risk exposure to offset.