Limitations of Derivatives

The limitations of derivatives are as follows:

  1. Speculative and Gambling Motives: As derivatives offer leveraged positions, it allows participants with even low capital to indulge in high volume trading. While it magnifies the gains, it also leads to higher losses if the trade goes wrong. Speculation has become one of the biggest motives behind the growth of the derivatives market.
  2. Increased Bankruptcies: The leverage in the derivatives may cause people to take more risk than they can handle. In the derivative market, one default may trigger a chain, causing a high amount of loss.
  3. Increase in Risk: The derivatives were initially designed to manage risk in the market. However, since then, the tools are mainly used for the purpose of speculation. This is especially true in Over the Counter (OTC) markets. Many of the derivatives fail to provide the risk cover they are designed for. In such situations, the leveraged positions may cause severe damage.
  4. Instability of Financial System: It is claimed that the use of derivatives has led to an overall increase in risk for the financial markets. The slow growth of derivatives has made the markets more liable for fluctuation, threatening the market’s stability and its participants.
  5. Price Instability: Derivatives were designed for price discovery and stability. However, the use of these tools for the purpose of speculation now causes the markets to have unstable pricing. The use of derivatives has also increased the range of fluctuations. The derivatives may cause price stability if these are used in a controlled manner.

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