Derivatives: Characteristics, Functions

and Uses
Meaning of Derivatives:
A derivative is an instrument whose value depends on the values of other
more basic underlying variables.

The underlying variables could be:

1. Stock prices,

2. Exchange rates, and

3. Interest rates.

These underlying variables are called cash market variables.

As an example ‘X’ consider the following financial contract:

1. There will be a gain of INR 100 if the closing price of Y share is Rs.
1008 tomorrow.

2. If the price does not move there will be no gain accruing to the investor.

The payoff that one may receive from the above contract is dependent or
derived on the share price. The above financial contract is an example of a
derivative contract. The payoff from such a contract is derived from the
behaviour of a underlying variable like a share price.

Characteristics of Derivatives:
1. Derivatives have the characteristic of Leverage or Gearing. With a small
initial outlay of funds (a small percentage of the entire contract value) one
can deal big volumes.
2. Pricing and trading in derivatives are complex and a thorough
understanding of the price behaviour and product structure of the
underlying is an essential pre-requisite before one can venture into dealing
in these products.

3. Derivatives, by themselves, have no independent value. Their value is

derived out of the underlying instruments.

Functions of Derivatives:
1. Derivatives shift the risk from the buyer of the derivative product to the
seller and as such are very effective risk management tools.

2. Derivatives improve the liquidity of the underlying instrument.

Derivatives perform an important economic function viz. price discovery.
They provide better avenues for raising money. They contribute
substantially to increasing the depth of the markets.

Users of Derivatives:
Hedgers, Traders and Speculators use derivatives for different purposes.
Hedgers use derivatives to protect their assets/positions from erosion in
value due to market volatility. Traders look for enhancing their income by
making a two-way price for other market participants. Speculators set their
eyes on making quick money by taking advantage of the volatile price
movements.

Hedging is a mechanism by which an investor seeks to protect his asset

from erosion in value due to adverse market price movements. A Hedger is
usually interested in streamlining his future cash flows. He is most
concerned when the market prices are very volatile. He is not concerned
with future positive potential of the value of underlying asset.
A speculator has, normally, no asset in his possession to protect. He is not
concerned with stabilising his future cash flows. He is interested only in
making quick money by taking advantage of the price movements in the
market. He is quite happy with volatility. In fact, volatility is his daily
bread and butter.

Arbitrageurs also form a segment of the financial markets. They make

riskless profit by exploiting the price differentials in different markets. For
example, if a company’s shares were trading at Rs. 3500 in Mumbai
market and Rs.3498 in Delhi market, an arbitrageur will buy it in Delhi
and sell it in Mumbai to make a riskless profit of Rs. 2 (transaction cost is
ignored for the purpose of this example).

Successive such transactions will iron out the difference in prices and
bring equilibrium in the market. However, arbitraging is not a very safe
way of making money as was proved in the case of Barings Bank where
unscrupulous arbitraging between Osaka and Tokyo exchanges in Nikkei
Stock index futures drove the Bank to bankruptcy.

Salient Points of Derivatives:

1. Financial Derivatives are products whose values are derived from the
values of the underlying assets.

2. Derivatives have the characteristics of high leverage and of being

complex in their pricing and trading mechanism.

3. Derivatives enable price discovery, improve the liquidity of the

underlying asset, serve as effective hedge instruments and offer better
ways of raising money.
4. The main players in a financial market include hedgers, speculators,
arbitrageurs and traders.

5. Hedging can be done in two ways viz. fixing a price (the linear way)
and taking an insurance (non-linear or asymmetric way).

There are a number of derivative contracts. Basically they are forwards,

futures and options. Forwards are definitive purchases and/or sales of a
currency or commodity for a future date. Forward contracts are contracted
for a particular value and should be transacted on a given date.

Forwards are useful in avoiding liquidity risk, price variations and locking
in avoiding a downside. Forward however has the limitation that the
contract has to be performed in full and has attendant credit risk and
market risk. Forwards are most useful in forex transactions where a spot
transaction can be covered by a contrary move in the forward market.

The other derivatives are futures and options.

Derivatives: Types, Considerations, and Pros and Cons

What Is a Derivative?
The term derivative refers to a type of financial contract whose value is dependent on
an underlying asset, group of assets, or benchmark. A derivative is set between two or more
parties that can trade on an exchange or over-the-counter (OTC).

These contracts can be used to trade any number of assets and carry their own risks. Prices
for derivatives derive from fluctuations in the underlying asset. These financial securities are
commonly used to access certain markets and may be traded to hedge against risk.
Derivatives can be used to either mitigate risk (hedging) or assume risk with the expectation
of commensurate reward (speculation). Derivatives can move risk (and the accompanying
rewards) from the risk-averse to the risk seekers.

KEY TAKEAWAYS

 Derivatives are financial contracts, set between two or more parties, that derive their value
from an underlying asset, group of assets, or benchmark.
 A derivative can trade on an exchange or over-the-counter.
 Prices for derivatives derive from fluctuations in the underlying asset.
  Derivatives are usually leveraged instruments, which increases their potential risks and
rewards.
 Common derivatives include futures contracts, forwards, options, and swaps.
Understanding Derivatives
A derivative is a complex type of financial security that is set between two or more parties.
Traders use derivatives to access specific markets and trade different assets. Typically,
derivatives are considered a form of advanced investing. The most common underlying assets
for derivatives are stocks, bonds, commodities, currencies, interest rates, and market indexes.
Contract values depend on changes in the prices of the underlying asset.

Derivatives can be used to hedge a position, speculate on the directional movement of an

underlying asset, or give leverage to holdings. These assets are commonly traded on
exchanges or OTC and are purchased through brokerages. The Chicago Mercantile
Exchange (CME) is among the world's largest derivatives exchanges.1

It's important to remember that when companies hedge, they're not speculating on the price of
the commodity. Instead, the hedge is merely a way for each party to manage risk. Each party
has its profit or margin built into the price, and the hedge helps to protect those profits from
being eliminated by market moves in the price of the commodity.

OTC-traded derivatives generally have a greater possibility of counterparty risk, which is the
danger that one of the parties involved in the transaction might default. These contracts trade
between two private parties and are unregulated. To hedge this risk, the investor could
purchase a currency derivative to lock in a specific exchange rate. Derivatives that could be
used to hedge this kind of risk include currency futures and currency swaps.

Exchange-traded derivatives are standardized and more heavily regulated than those that are
traded over-the-counter.

Special Considerations
Derivatives were originally used to ensure balanced exchange rates for internationally traded
goods. International traders needed a system to account for the differing values of national
currencies.

Assume a European investor has investment accounts that are all denominated in euros
(EUR). Let's say they purchase shares of a U.S. company through a U.S. exchange using U.S.
dollars (USD). This means they are now exposed to exchange rate risk while holding that
stock. Exchange rate risk is the threat that the value of the euro will increase in relation to the
USD. If this happens, any profits the investor realizes upon selling the stock become less
valuable when they are converted into euros.

A speculator who expects the euro to appreciate versus the dollar could profit by using a
derivative that rises in value with the euro. When using derivatives to speculate on the price
movement of an underlying asset, the investor does not need to have a holding
or portfolio presence in the underlying asset.

Many derivative instruments are leveraged, which means a small amount of capital is
required to have an interest in a large amount of value in the underlying asset.
Types of Derivatives
Derivatives today are based on a wide variety of transactions and have many more uses.
There are even derivatives based on weather data, such as the amount of rain or the number
of sunny days in a region.

There are many different types of derivatives that can be used for risk
management, speculation, and leveraging a position. The derivatives market is one that
continues to grow, offering products to fit nearly any need or risk tolerance.

There are two classes of derivative products: "lock" and "option." Lock products (e.g.,
futures, forwards, or swaps) bind the respective parties from the outset to the agreed-upon
terms over the life of the contract. Option products (e.g., stock options), on the other hand,
offer the holder the right, but not the obligation, to buy or sell the underlying asset or security
at a specific price on or before the option's expiration date. The most common derivative
types are futures, forwards, swaps, and options.

Futures

A futures contract, or simply futures, is an agreement between two parties for the purchase
and delivery of an asset at an agreed-upon price at a future date. Futures are standardized
contracts that trade on an exchange. Traders use a futures contract to hedge their risk or
speculate on the price of an underlying asset. The parties involved are obligated to fulfill a
commitment to buy or sell the underlying asset.

For example, say that on Nov. 6, 2021, Company A buys a futures contract for oil at a price
of $62.22 per barrel that expires Dec. 19, 2021. The company does this because it needs oil in
December and is concerned that the price will rise before the company needs to buy. Buying
an oil futures contract hedges the company's risk because the seller is obligated to deliver oil
to Company A for $62.22 per barrel once the contract expires. Assume oil prices rise to $80
per barrel by Dec. 19, 2021. Company A can accept delivery of the oil from the seller of the
futures contract, but if it no longer needs the oil, it can also sell the contract before expiration
and keep the profits.

In this example, both the futures buyer and seller hedge their risk. Company A needed oil in
the future and wanted to offset the risk that the price may rise in December with a long
position in an oil futures contract. The seller could be an oil company concerned about falling
oil prices that wanted to eliminate that risk by selling or shorting a futures contract that fixed
the price it would get in December.

It is also possible that one or both of the parties are speculators with the opposite opinion
about the direction of December oil. In that case, one might benefit from the contract, and
one might not. Take, for example, the futures contract for West Texas Intermediate (WTI) oil
that trades on the CME and represents 1,000 barrels of oil. If the price of oil rose from $62.22
to $80 per barrel, the trader with the long position—the buyer—in the futures contract would
have profited $17,780 [($80 - $62.22) x 1,000 = $17,780].2 The trader with the short position
—the seller—in the contract would have a loss of $17,780.

Cash Settlements of Futures

Not all futures contracts are settled at expiration by delivering the underlying asset. If both
parties in a futures contract are speculating investors or traders, it is unlikely that either of
them would want to make arrangements for the delivery of a large number of barrels of crude
oil. Speculators can end their obligation to purchase or deliver the underlying commodity by
closing (unwinding) their contract before expiration with an offsetting contract.

Many derivatives are, in fact, cash-settled, which means that the gain or loss in the trade is
simply an accounting cash flow to the trader's brokerage account. Futures contracts that are
cash-settled include many interest rate futures, stock index futures, and more unusual
instruments such as volatility futures or weather futures.

Forwards

Forward contracts, or forwards, are similar to futures, but they do not trade on an exchange.
These contracts only trade over-the-counter. When a forward contract is created, the buyer
and seller may customize the terms, size, and settlement process. As OTC products, forward
contracts carry a greater degree of counterparty risk for both parties.

Counterparty risks are a type of credit risk in that the parties may not be able to live up to the
obligations outlined in the contract. If one party becomes insolvent, the other party may have
no recourse and could lose the value of its position.

Once created, the parties in a forward contract can offset their position with other
counterparties, which can increase the potential for counterparty risks as more traders become
involved in the same contract.

Swaps

Swaps are another common type of derivative, often used to exchange one kind of cash flow
with another. For example, a trader might use an interest rate swap to switch from a variable
interest rate loan to a fixed interest rate loan, or vice versa.

Imagine that Company XYZ borrows $1,000,000 and pays a variable interest rate on the loan
that is currently 6%. XYZ may be concerned about rising interest rates that will increase the
costs of this loan or encounter a lender that is reluctant to extend more credit while the
company has this variable-rate risk.

Assume XYZ creates a swap with Company QRS, which is willing to exchange the payments
owed on the variable-rate loan for the payments owed on a fixed-rate loan of 7%. That means
that XYZ will pay 7% to QRS on its $1,000,000 principal, and QRS will pay XYZ 6%
interest on the same principal. At the beginning of the swap, XYZ will just pay QRS the 1
percentage-point difference between the two swap rates.

If interest rates fall so that the variable rate on the original loan is now 5%, Company XYZ
will have to pay Company QRS the 2 percentage-point difference on the loan. If interest rates
rise to 8%, then QRS would have to pay XYZ the 1 percentage-point difference between the
two swap rates. Regardless of how interest rates change, the swap has achieved XYZ's
original objective of turning a variable-rate loan into a fixed-rate loan.
Swaps can also be constructed to exchange currency-exchange rate risk or the risk of default
on a loan or cash flows from other business activities. Swaps related to the cash flows and
potential defaults of mortgage bonds are an extremely popular kind of derivative. In fact,
they've been a bit too popular in the past. It was the counterparty risk of swaps like this that
eventually spiraled into the credit crisis of 2008.

Options

An options contract is similar to a futures contract in that it is an agreement between two

parties to buy or sell an asset at a predetermined future date for a specific price. The key
difference between options and futures is that with an option, the buyer is not obliged to
exercise their agreement to buy or sell. It is an opportunity only, not an obligation, as futures
are. As with futures, options may be used to hedge or speculate on the price of the underlying
asset.

In terms of timing your right to buy or sell, it depends on the "style" of the option. An
American option allows holders to exercise the option rights at any time before and including
the day of expiration. A European option can be executed only on the day of expiration. Most
stocks and exchange-traded funds have American-style options while equity indexes,
including the S&P 500, have European-style options.

Imagine an investor owns 100 shares of a stock worth $50 per share. They believe the stock's
value will rise in the future. However, this investor is concerned about potential risks and
decides to hedge their position with an option. The investor could buy a put option that gives
them the right to sell 100 shares of the underlying stock for $50 per share—known as
the strike price—until a specific day in the future—known as the expiration date.

Assume the stock falls in value to $40 per share by expiration and the put option buyer
decides to exercise their option and sell the stock for the original strike price of $50 per share.
If the put option cost the investor $200 to purchase, then they have only lost the cost of the
option because the strike price was equal to the price of the stock when they originally bought
the put. A strategy like this is called a protective put because it hedges the stock's downside
risk.

Alternatively, assume an investor doesn't own the stock currently worth $50 per share. They
believe its value will rise over the next month. This investor could buy a call option that gives
them the right to buy the stock for $50 before or at expiration. Assume this call option cost
$200 and the stock rose to $60 before expiration. The buyer can now exercise their option
and buy a stock worth $60 per share for the $50 strike price for an initial profit of $10 per
share. A call option represents 100 shares, so the real profit is $1,000, less the cost of the
option—the premium—and any brokerage commission fees.

In both examples, the sellers are obligated to fulfill their side of the contract if the buyers
choose to exercise the contract. However, if a stock's price is above the strike price at
expiration, the put will be worthless and the seller (the option writer) gets to keep the
premium as the option expires. If the stock's price is below the strike price at expiration, the
call will be worthless and the call seller will keep the premium.

Advantages and Disadvantages of Derivatives

Advantages

As the above examples illustrate, derivatives can be a useful tool for businesses and investors
alike. They provide a way to do the following:

 Lock in prices
 Hedge against unfavorable movements in rates
 Mitigate risks

These pluses can often come for a limited cost.

Derivatives also can often be purchased on margin, which means traders use borrowed funds
to purchase them. This makes them even less expensive.

Disadvantages

Derivatives are difficult to value because they are based on the price of another asset. The
risks for OTC derivatives include counterparty risks that are difficult to predict or value.
Most derivatives are also sensitive to the following:

 Changes in the amount of time to expiration

 The cost of holding the underlying asset
 Interest rates

These variables make it difficult to perfectly match the value of a derivative with the
underlying asset.

Because the derivative has no intrinsic value (its value comes only from the underlying
asset), it is vulnerable to market sentiment and market risk. It is possible for supply and
demand factors to cause a derivative's price and its liquidity to rise and fall, regardless of
what is happening with the price of the underlying asset.

Finally, derivatives are usually leveraged instruments, and using leverage cuts both ways.
While it can increase the rate of return, it also makes losses mount more quickly.

Pros

 Lock in prices

 Hedge against risk

 Can be leveraged

 Diversify portfolio

Cons
  Hard to value

 Subject to counterparty default (if OTC)

 Complex to understand

 Sensitive to supply and demand factors

What Are Derivatives?

Derivatives are securities whose value is dependent on or derived from an underlying asset.
For example, an oil futures contract is a type of derivative whose value is based on the market
price of oil. Derivatives have become increasingly popular in recent decades, with the total
value of derivatives outstanding was estimated at $610 trillion at June 30, 2021.3

What Are Some Examples of Derivatives?

Common examples of derivatives include futures contracts, options contracts, and credit
default swaps. Beyond these, there is a vast quantity of derivative contracts tailored to meet
the needs of a diverse range of counterparties. In fact, because many derivatives are traded
over-the-counter (OTC), they can in principle be infinitely customized.

What Are the Main Benefits and Risks of Derivatives?

Derivatives can be a very convenient way to achieve financial goals. For example, a company
that wants to hedge against its exposure to commodities can do so by buying or selling energy
derivatives such as crude oil futures. Similarly, a company could hedge its currency risk by
purchasing currency forward contracts. Derivatives can also help investors leverage their
positions, such as by buying equities through stock options rather than shares. The main
drawbacks of derivatives include counterparty risk, the inherent risks of leverage, and the fact
that complicated webs of derivative contracts can lead to systemic risks.
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Home › Resources › Derivatives › Derivatives

Table of contents

 What are Derivatives?

 Types of Derivatives
o Options
o Futures
o Forwards
o Swaps
  Vanilla versus Exotic Derivatives
 The Derivatives Market

o Derivatives market history

o Participants in the derivatives market
 What are Exchange-Traded Derivatives?
o Types of exchange-traded derivatives
o Clearing and settlement of exchange-traded derivatives
o Benefits of exchange-traded derivatives
o Disadvantage of exchange-traded derivatives
o Learn More

Derivatives
Explore the types and uses of these financial contracts

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Written by Andrew Loo

What are Derivatives?

Derivatives are financial contracts whose value is linked to the

value of an underlying asset. They are complex financial
instruments that are used for various purposes, including
speculation, hedging and getting access to additional assets or
markets.
Key Highlights

 Derivatives are powerful financial contracts whose value is

linked to the value or performance of an underlying asset or
instrument and take the form of simple and more
complicated versions of options, futures, forwards and
swaps.
 Users of derivatives include hedgers, arbitrageurs,
speculators and margin traders.
 Derivatives are traded over-the-counter bilaterally between
two counterparties but are also traded on exchanges.
Types of Derivatives

Derivative contracts can broken down into the following four

types:

Options

Options are financial derivative contracts that give the buyer the
right, but not the obligation, to buy or sell an underlying asset at
a specific price (referred to as the strike price) during a specific
period of time. American options can be exercised at any time
before the expiry of its option period. On the other hand,
European options can only be exercised on its expiration date.

Futures

Futures contracts are standardized contracts that allow the holder

of the contract to buy or sell the respective underlying asset at an
agreed price on a specific date. The parties involved in a futures
contract not only possess the right but also are under the
obligation to carry out the contract as agreed.

Futures contracts are traded on the exchange market and as such,

they tend to be highly liquid, intermediated and regulated by the
exchange.

Because of the highly standardized nature of futures contracts, it

is easy for buyers and sellers to unwind or close out their
exposure before the expiration of the contract.

Forwards

Forwards contracts are similar to futures contracts in the sense

that the holder of the contract possesses not only the right but is
also under the obligation to carry out the contract as agreed.
However, forwards contracts are over-the-counter products, which
means they are not regulated and are not bound by specific
trading rules and regulations.

Since such contracts are unstandardized, they are customizable

to suit the requirements of both parties involved. Given the
bespoke nature of forward contracts, they tend to be generally
held until the expiry and delivered into, rather than be unwound.

Swaps

Swaps are derivative contracts that involve two holders, or parties

to the contract, to exchange financial obligations. Interest rate
swaps are the most common swaps contracts entered into by
investors. Swaps are not traded on the exchange market. They
are traded over the counter, because of the need for swaps
contracts to be customizable to suit the needs and requirements
of both parties involved.

As the market’s needs have developed, more types of swaps have

appeared, such as credit default swaps, inflation swaps and total
return swaps.

The Derivatives Market

Most derivatives are traded over-the-counter (OTC) on a bilateral

basis between two counterparties, such as banks, asset
managers, corporations and governments. These professional
traders have signed documents in place with one another to
ensure that everyone is in agreement on standard terms and
conditions.

However, some of the contracts, including options and futures,

are traded on specialized exchanges. The biggest derivative
exchanges include the CME Group (Chicago Mercantile Exchange
and Chicago Board of Trade), the National Stock Exchange of India,
and Eurex.

Derivatives can be bought and sold on almost any capital market

asset class, such as equities, fixed income, commodities, foreign
exchange and even cryptocurrencies.

Derivatives market history

Derivatives are not new financial instruments. For example, the
emergence of the first futures contracts can be traced back to the
second millennium BC in Mesopotamia. However, the financial
instrument was not widely used until the 1970s. The introduction
of new valuation techniques sparked the rapid development of
the derivatives market. Nowadays, we cannot imagine modern
finance without derivatives.

Derivatives are very powerful and complex financial instruments

and as such, have been at the heart of various financial crises
throughout history, the most recent being the Global Financial
Crisis of 2008, where derivatives linked to the U.S. housing
market and credit instruments caused the failure of venerable
firms Lehman Brothers, Bear Stearns and forced sale of Merrill-
Lynch.

Participants in the derivatives market

The participants in the derivatives market can be broadly

categorized into the following four groups:

Hedgers: Hedgers use financial markets instruments, such as

derivatives, to reduce their existing risk or future exposure. An
example might be a farmer who sells cattle futures now in order
to reduce price uncertainty when her herd is finally ready to be
sold. Another example might be a bond issuer that uses interest
rate swaps to convert their future bond interest obligation to
better match their expected future cashflows.

A derivative is a very popular hedging instrument since its

performance is derived, or linked, to the performance of the
underlying asset.

Speculators: Speculation is a common, but risky, market activity

for financial market participants of a financial market take part in.
Speculators take an educated gamble by either buying or selling
an asset in the expectation of short-term gains. It is risky because
the trade can move against the speculator just as quickly,
resulting in potentially significant losses.

Since using derivatives, especially options, is an inexpensive and

highly liquid way to gain exposure to an asset without necessarily
owning that asset, derivatives are a very important part of the
arsenal for financial market speculators. As an example, a
speculator can buy an option on the S&P 500 that replicates the
performance of the index without having to come up with the
cash to buy each and every stock in the entire basket. If that
trade works in the speculators favor in the short term, she can
quickly and easily close her position to realize a profit by selling
that option since S&P 500 options are very frequently traded.

Arbitrageurs: Arbitrage is a very common activity in financial

markets that comes into effect by taking advantage of mispricings
in assets, resulting in risk-free profits. For example, let’s consider
a situation where gold futures trade much higher than the spot
price of gold. An arbitrageur may sell the gold future, purchase
the gold now at spot, store it and deliver it into the futures
contract to essentially lock-in riskless profit.

Arbitrageurs are therefore, an important part of the derivative

markets as they ensure that the relationships between certain
assets are kept in check.

Margin traders: In finance terms, margin is the collateral

deposited by an investor with their broker or the exchange in
order to borrow money to leverage their investment power. By
employing leverage, a trader is able magnify gains but also may
suffer larger losses.

Derivatives are often used by margin traders, especially in foreign

exchange trading, since it would be incredibly capital-intensive to
fund purchases and sales of the actual currencies. Another
example would be cryptocurrencies, where the sky-high price
of Bitcoin makes it very expensive to buy. Margin traders would
use the leverage provided by Bitcoin futures in order to not tie up
their trading capital and also amplify potential returns.

What are Exchange-Traded Derivatives?

Exchange-traded derivatives (ETD) consist mostly of options and

futures traded on public exchanges, with a standardized contract.
Through the contracts, the exchange determines an expiration
date, settlement process, and lot size, and specifically states the
underlying instruments on which the derivatives can be created.

Hence, exchange-traded derivatives promote transparency and

liquidity by providing market-based pricing information. In
contrast, over-the-counter derivatives are traded privately and
are tailored to meet the needs of each party, making them less
transparent and much more difficult to unwind.
Only members of the exchange are allowed to transact on the
exchange and only after they pass the exchange’s requirements
to be a member. These may include financial assessments of the
member, regulatory compliance and other requirements designed
to protect the integrity of the exchange and the other members,
as well as to ensure the stability of the market.

Types of exchange-traded derivatives

Stock or equity derivatives: Common stock is the most

commonly traded asset class used in exchange-traded derivatives.

As exchange-traded derivatives tend to be standardized, not only

does that improve the liquidity of the contract, but also means
that there are many different expiries and strike prices to choose
from.

Global stock derivatives are also seen to be a leading indicator of

future trends of common stock values.

Index derivatives: Not only are you able to transact derivatives

in single-name stocks, but you can also trade derivatives tied to
the performance of a stock index or basket of stocks.

Index-related derivatives are sold to investors that would like to

buy or sell an entire exchange instead of simply futures of a
particular stock. Physical delivery of the index is impossible
because there is no such thing as one unit of the S&P or TSX.

Currency derivatives: Exchange-traded derivatives markets list

a common currency pairs for trading. Futures contracts or options
are available for the pairs, and investors can choose to go long or
short.

Interestingly, currency derivatives also allow for investors to

access certain FX markets that may be closed to outsiders or
where forward FX trading is banned. These derivatives, called non-
deliverable forwards (NDF), are traded offshore and settle in a
freely-traded currency, mostly USD. However, NDFs tend to trade
OTC rather than on an exchange.

Commodities derivatives: Derivatives trading in commodities

includes futures and options that are linked to physical assets or
commodities. Most commonly, we see trading in oil and gas
futures, agricultural and metals.
These are very important not only for the producers of
commodities, such as oil companies, farmers and miners, but also
a way that downstream industries that rely on the supply of these
commodities hedge their costs.

Recently, we have even seen the market develop for

cryptocurrency futures on leading tokens such as Bitcoin
and Ethereum.

Interest rate derivatives: Another family of commonly traded

ETDs are those related to fixed income products, such as
government bond futures. These bond futures give fixed income
traders an efficient and effective way to manage their interest risk
exposure.

While many interest rate derivatives are always available on

exchanges, after the Wall Street Reform and Consumer Protection Act
of 2010 (also known as the “Dodd-Frank Act”) was passed after
the Global Financial Crisis, we have seen more and more OTC
derivatives move onto exchanges, such as credit default
swaps (CDS).

Clearing and settlement of exchange-traded derivatives

While an OTC derivative is cleared and settled bilaterally between

the two counterparties, ETDs are not. While both buyer and seller
of the contract agree to trade terms with the exchange, the actual
clearing and settlement is done by a clearinghouse.

Clearing houses will handle the technical clearing and settlement

tasks required to execute trades. All derivative exchanges have
their own clearing houses and all members of the exchange who
complete a transaction on that exchange are required to use the
clearing house to settle at the end of the trading session. Clearing
houses are also heavily regulated to help maintain financial
market stability.

Clearing houses ensure a smooth and efficient way to clear and

settle cash and derivative trades. For derivatives, these clearing
houses require an initial margin in order to settle through a
clearing house. Moreover, in order to hold the derivative position
open, clearing houses will require the derivative trader to
post maintenance margins to avoid a margin call.
If the trader cannot post the cash or collateral to make up the
margin shortfall, the clearing house may liquidate sufficient
securities or unwind the derivative position to bring the account
back into good standing.

The clearing house then, is effectively the counterparty for the

transaction that faces the trader and not the other party as would
be the case in an OTC transaction. By stepping in between the
buyer and seller of a derivative contract, the clearing house
guarantees that trades will be successfully completed and more
importantly, that traders who are on the losing end of a derivative
transaction have the ability to pay their obligation. This reduces
much of the counterparty credit risk present in an OTC derivative
transaction.

Benefits of exchange-traded derivatives

Highly liquid. Exchange-traded derivatives have standardized

contracts with a transparent price, which enables them to be
bought and sold easily. Investors can take advantage of the
liquidity by offsetting their contracts when needed. They can do
so by selling the current position out in the market or buying
another position in the opposite direction.

The offsetting transactions can be performed in a matter of

seconds without needing any negotiations, making exchange-
traded derivatives instruments significantly more liquid.

High liquidity also makes it easier for investors to find other

parties to sell to or make bets against. Since more investors are
active at the same time, transactions can be completed in a way
that minimizes value loss.

Intermediation reduces the risk of default. Exchange-traded

derivatives are also beneficial because they prevent both
transacting parties from dealing with each other through
intermediation. Both parties in a transaction will report to the
exchange; therefore, neither party faces a counterparty risk.

The intermediate party, the clearinghouse, will act as an

intermediary and assume the financial risk of their clients. By
doing so, it effectively reduces counterparty credit risk for
transacting parties.
Regulated exchange platform. The exchange is considered to
be safer because it is subject to a lot of regulation. The exchange
also publishes information about all major trades in a day.
Therefore, it does a good job of preventing the few big
participants from taking advantage of the market in their favor.

Disadvantage of exchange-traded derivatives

Loss of flexibility. The standardized contracts of exchange-

traded derivatives cannot be tailored and therefore make the
market less flexible. There is no negotiation involved, and much
of the derivative contract’s terms have been already predefined.