Participants and Functions of Derivatives Markets

Participants:

1. Hedgers: These individuals or entities use derivatives to reduce their exposure to existing risks. For instance, a farmer might sell futures contracts on their crops to protect against price declines, or a company expecting a foreign currency payment might use a forward contract to lock in an exchange rate.
2. Speculators: Speculators, unlike hedgers, take on risk by entering into derivative contracts to profit from anticipated price movements. They don't have an underlying exposure to hedge; instead, they bet on the direction of the underlying asset's price.
3. Arbitrageurs: Arbitrageurs seek to profit from price discrepancies between related assets or markets. They might exploit differences in pricing between a derivative and its underlying asset or between similar derivatives traded on different exchanges.
4. Dealers (Market Makers): In both exchange-traded and OTC markets, dealers act as intermediaries, providing liquidity by buying and selling derivatives. They earn profits primarily from the bid-ask spread.
5. End Users: These are the ultimate buyers and sellers of derivatives, including corporations, investors, and financial institutions.

Functions:

1. Risk Transfer: Derivatives allow for the transfer of risk from one party to another. Hedgers can offload unwanted risks, while speculators willingly take them on.
2. Price Discovery: Derivatives markets, especially futures markets, provide valuable information about market expectations for future prices of underlying assets.
3. Market Efficiency: Derivatives can enhance market efficiency by providing a mechanism for hedging, speculation, and arbitrage. This can lead to more accurate pricing of assets and better allocation of capital.
4. Leverage: Derivatives enable investors to gain exposure to a large amount of the underlying asset with a relatively small investment. This leverage can amplify both gains and losses.
5. Lower Transaction Costs: Trading derivatives often involves lower transaction costs compared to trading the underlying asset directly, especially in cases where the underlying is illiquid or difficult to trade.