The question of the economic functions of derivatives has been widely discussed in the financial economics literature. In this paper, I focus on the sources of economic efficiency gains from the use of derivatives. These sources include helping to complete capital markets, lowering transaction costs, and reducing agency costs. Many of these functions can be obtained by using primary securities so an important question is what characteristics of derivatives account for their enhanced efficiency and utility relative to the assets that underlie them. Three characteristics are identified and discussed: 1) the dependence of derivative value on changes in the value of underlying assets, 2) the positive dependence of some derivative values on asset volatility, and 3) the non-linear payoffs provided by some derivatives.
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