Financial derivatives play a pivotal role in risk management and growth strategies alike, providing protection from market risk (all investments are susceptible to market fluctuations), counterparty credit risk (in the event one party involved in a trade defaults), and liquidity risks.
Derivatives support international trade through investment channels by reducing currency and price volatility and disincentive for exporting and importing, thus improving firm performance.
Size of the underlying market
Size of Underlying Market A key factor affecting how liquid the derivatives market will be is its underlying market size, since no derivative instrument can act independently as an investment without its matching asset (such as currency or stocks). Investors use derivatives to speculate on future values of assets they own such as currency or stocks. Conversely, less liquid underlying markets make finding buyers for derivatives more challenging.
Researchers have conducted extensive studies of the factors determining the success of derivatives markets to gain an understanding of what determines market success. These factors can be divided into two categories: characteristics of both the underlying market and derivatives market (such as futures or options). Some research studies also looked at additional elements – legal, economic and political environments; these results can assist policymakers in devising strategies to promote their growth.
Volatility of the underlying market
Trading volatility is an integral element to understanding how well a derivative performs. Traders utilize it as an indicator for potential price movements over a trading day, market impact models, value-at-risk calculations and portfolio selection strategies.
Many underlying assets can be highly volatile, which can have an effect on derivatives in various ways. For instance, when an investor purchases shares of an European company using U.S. dollars instead of euros as this represents exchange rate risk.
Derivatives are leveraged instruments, meaning a relatively modest initial capital outlay is sufficient to purchase an expansive position in an underlying asset. While this increases potential returns and risks associated with derivatives, this study investigates their relationship with liquidity and volatility using data from four Asian emerging economies and also incorporates regulatory economic factor EPU as a moderator; previous studies had not taken this approach [38]. Results show a negative correlation between EPU and liquidity.
Liquidity of the underlying market
Liquidity of an underlying market is a critical component of successful derivatives markets, impacting investors’ ability to trade efficiently as well as the size of brokers’ commissions. Furthermore, market volatility has an immediate bearing on derivatives based on it.
This study employs the Amihud price impact measure to investigate both short- and long-term impacts of derivative trading on market liquidity. It tests the hypothesis that when new derivatives are introduced, their trading volume leads to an increase in market liquidity for their underlying stocks; its findings revealed an increase in liquidity six months and one year post-derivative listing.
Liquidity of financial markets is essential to a stable economy. Investors should understand what influences market liquidity and its fluctuations during crisis situations; for example, illiquid assets often signal uncertainty regarding future economic outcomes.
Open interest in the underlying market
Open interest is the number of options and futures contracts that have not yet been closed out or exercised, although this does not indicate the total volume of trades between buyers and sellers; this metric instead captures this totality through trading volume metrics. Rising open interest can indicate new money entering the market to support current price trends while declining open interest may indicate liquidation that could signal price reversals ahead.
Investors can use open interest data to assess the level of interest for various strikes and prices, and determine which are attracting speculator attention. It should be noted, however, that open interest does not predict price movements alone – for an accurate picture of market sentiment it must be evaluated alongside trading volume and other indicators.