Derivatives refer to the financial instruments which derive their value from the underlying assets, security, index, or commodity, traded on organized exchanges or in the over-the-counter markets. It is a contract between a buyer and a seller concerning an agreement to be fulfilled at a specific point in time. That being said, as Exchanges migrate towards fully electronic structures, there is far less differentiation between Exchange-Traded and OTC markets.
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What are Exchange-Traded Derivatives?
Exchange-traded derivative contracts are traded in regulated exchanges. They mostly consist of options and futures and can be used to hedge or speculate on a wide range of assets like currencies, interest rates, etc.
The standardization of contracts is a core element of exchange-traded derivatives. This implies that the terms and conditions are defined by the exchange specifically. The Exchange decides the expiry date, the settlement process, the size of the lot, and, in particular, the underlying instruments on which the derivatives may be formed. This also helps to ensure that securities are cleared and settled efficiently and enables credit guarantees to be issued through the clearinghouse.
Exchange-traded derivatives, therefore, foster liquidity and transparency by offering market-based price quotes. As an alternative approach to standardization, over-the-counter derivatives are traded individually and customized to meet each party’s requirements, thereby minimizing transparency.
Types of Exchange-traded derivatives:
- Stock derivatives
- Index derivatives
- Currency derivatives
- Commodities derivatives
- Real estate derivatives
Clearing and settlement of exchange-traded derivatives:
Exchange-Traded derivatives need an initial deposit settled by a clearinghouse. The technical clearing and settlement tasks are taken care of by the clearinghouse. Most exchange-traded derivatives are also traded through a central counterparty (CCP).
Benefits of exchange-traded derivatives:
- Highly liquid: Since these contracts are transparently priced, they are bought and sold easily. Investors also have the advantage of offsetting their contracts whenever required. High liquidity makes it easier to find buyers and sellers and so losses can be minimized.
- Regulated platform: Due to the amount of regulation, the market is considered to be very safe. The exchange publishes information about important trades preventing the few big players to influence the market in their favor.
- Reduction in default risk: Neither parties face counterparty risk as they both are answerable to the exchange who is the intermediary party. The exchange assumes the risk of both the clients and thus reduces default risk for both parties.
Risks involved in exchange-traded derivatives:
- Less flexibility: Since the exchange-traded derivatives have standardized contracts, the market is less flexible. There is no room for negotiation as in OTC markets.
- Not be suitable for all investors: Standardized contracts, for example, may not be considered by institutions that typically trade vast volumes of derivatives due to their lower notional value and lack of customization of exchange-traded derivatives.
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Author – Abha Shetty
About the author – Abha is a second-year BMS student and FRM level 1 candidate. She is very intrigued by the world of financial markets and hopes to master the art of investing and trading.