What is the Derivatives Market?
A derivatives market is a financial marketplace where derivatives like futures and options are traded consists of financial instruments that are used for hedging purposes or for speculation by both individual as well as institutional investors. Based on trading motives, the major players in this market are hedgers, arbitrageurs, margin traders, and speculators.
The two major parts of the global derivative market are exchange-traded derivatives and over-the-counter derivatives. The legal nature and the mode of trade of both these derivatives are extremely different and can vary from country to country as well. In the 2007-08 financial crisis, the Credit Default Swaps (CDSs) were part of the downfall of the economy and corrective actions have been taken ever since.
Table of contents
- The derivatives market is a financial market where various types of derivatives instruments are bought and sold.
- It serves as a platform for participants to manage risk, speculates on price movements, and gain exposure to different asset classes.
- The derivatives market includes organized exchanges, such as futures and options exchanges, and over-the-counter (OTC) markets where customized derivative contracts are traded.
- The derivatives market plays a crucial role in global finance, contributing to market liquidity, price discovery, and efficient capital allocation.
Derivatives Market Explained
The derivative market is a financial marketplace where derivatives are traded. Derivative instruments can either be traded on the exchange or over the counter.
Options and futures contracts are constituents of exchange-traded derivatives, whereas an over-the-counter market can also include swaptions and forwards along with options and futures contracts.
Derivatives allow investors and traders to hedge their risks in other positions that they have entered into. Since the return on investment is huge as compared to the risk involved, investors tend to invest in the derivatives market.
After the 2007-08 financial crisis, where the Credit Default Swaps (CDSs) played their role in the downfall of the economy, the regulators and government officials have made considerable efforts to better the screening process and put an impetus on educating the common citizen.
It is vital to keep a few factors that have been suggested as reforms at the G20 meetings with regard to the derivatives market trading including prioritizing risk management, high capital standards, laying out capital rules, and international surveillance.
Depending on the terms and conditions and legal terms, ethe global derivatives market can be divided into two parts, namely:
#1 – Exchange Traded Derivatives
They consist of derivative contractsDerivative ContractsDerivative Contracts are formal contracts entered into between two parties, one Buyer and the other Seller, who act as Counterparties for each other, and involve either a physical transaction of an underlying asset in the future or a financial payment by one party to the other based on specific future events of the underlying asset. In other words, the value of a Derivative Contract is derived from the underlying asset on which the Contract is based. that are traded on a regulated market. These are standardized futures or options contracts that are traded on organized markets hence require initial payment while entering the contract as a margin. Investors and traders prefer to exchange-traded derivatives since it eliminates a certain amount of defaulting risk and has a standard structure that needs to be followed.
The below image shows the market notional of various derivative markets across the globe:
The exchange-traded derivatives have special codes depending on the month in which the contract expires. Across the market, the code for the contract would remain the same. Even if the market price for the contract can be checked on Bloomberg or Reuters using the codes depending on the contract expiry month. All contracts have a generic prefix code followed by the expiry month code and the year.
The codes for the expiry month are as below:
#2 – Over the Counter (OTC)
Over the counter, trades are private trades between two parties. The deal is made between the parties involved and is unknown to the external market. The major difference between exchange-traded and Over the counter trade is that of the place at which the trade takes place. There are no intermediaries involved in the transaction, either. An over the counter trade does not involve being traded in the market. Over the counterOver The CounterOver the counter (OTC) is the process of stock trading for the companies that don't hold a place on formal exchange listings. The broker-dealer network facilitates such decentralized trading of derivatives, equity and debt instruments., trades are not as structured as exchange-traded derivatives and hence can be modified and customized as per the trading needs of the parties involved in the transaction. Unlike exchange-traded derivatives, there is no specific nomenclature for over the counter derivatives, and it follows the same codes as exchange-traded derivatives.
Let us understand the concept of derivatives market trading with the help of a couple of examples. These examples will give us a practical understanding of the concept and its related factors.
A 2-Year U.S. Treasury Note has a generic code as ‘TU’ so a 2-Year Treasury Note that expires in September 2019 will have a code as ‘TUU9’.Similarly, a 2-Year U.S. Treasury Note that expires in Feb 2020 will have a code as ‘TUG0.’
A futures contract for 2-Year U.S. Treasury NoteTreasury NoteTreasury Notes are government-issued instruments with a fixed rate of interest and maturity date. As a result, it is the most preferred option because it is issued by the government (therefore, there is no risk of default) and also gives a guaranteed amount as a return, allowing the investor to plan accordingly., which expires in September 2019 that is traded on the Chicago Mercantile Exchange (CME), is an example of an exchange-traded derivative.
Similarly, any options trade or any futures contract that is traded on the exchange will be an exchange-traded derivative. Equity options, bond options, bond futuresBond FuturesBond Futures is a contract that puts liability on the holder to purchase and sell a fixed amount of bonds as specified in the contract agreement at a price which is predetermined by the contract holder where the other side is the exchange. It can be bought and sold in the exchange market, the price and dates are standardized at the time when an agreement is entered into by the holder. are a few derivatives to name a few that are traded on the exchange.
Swaptions are perfect examples of over the counter derivatives trades, although counterparties can also trade a futures contract over the contract when it is an over the counter derivative trade, it is called a forward contractForward ContractA forward contract is a customized agreement between two parties to buy or sell an underlying asset in the future at a price agreed upon today (known as the forward price).. Swaptions can be classified as Bermudan, European, or American, depending on the terms of the contract. The Bermudan swaption allows the purchaser to exercise the option at specific predetermined dates and swap the options. Just like European optionsEuropean OptionsA European option can be defined as a type of options contract (call or put option) that restricts its execution until the expiration date. In layman's terms, once an investor has purchased a European option, even if the underlying security's price moves in a favourable direction, the investor cannot take advantage by exercising the option early., the European swaptions can be exercised only at the expiration date. The same goes for American swaptions, like American optionsAmerican OptionsAn American option is a type of options contract (call or put) that can be exercised at any time at the holder's will of the opportunity before the expiration date. It allows the option holder to reap benefits from the security or stock at any time when the safety or supply is favorable. A European option is the exact opposite of an American option wherein the option holder cannot sell the option until the day of expiration, even when it is favorable. In addition, there is no geographical connection concerning the names since it only refers to the execution of the options trade., these can be exercised at any time the option holder finds the contract favorable to exercise.
Let us understand the importance of derivatives market trading through the points below.
- It is a mammoth market that has traders all over the world, investing each day.
- The over the counter derivative trades are much more popular and have a $600 trillion market value.
- Even though the notional amount for derivative trades is high, the market value is declining due to the financial slowdown in the global economy.
- Trading is high in the derivatives market due to speculation and hedging activities done by traders in a bid to earn from favorable market conditions.
- Unlike traditional trading, which is straightforward, derivative trading requires a sound knowledge of the market and the trends.
Let us understand the advantages of the global derivative market for traders, hedgers, speculators, and other players in the market through the discussion below.
- Enables smooth trading of derivative instruments.
- Attracts investors due to its luring returns that can get a person to earn multiples of their initial investment.
- Creates opportunities for hedging investment options.
- Investors can either invest in an exchange-traded derivative or over the counter derivative depending on the risk he/she is willing to take.
- Investing in a derivative instrument involves higher risk than investing in the primary or secondary marketSecondary MarketA secondary market is a platform where investors can easily buy or sell securities once issued by the original issuer, be it a bank, corporation, or government entity. Also referred to as an aftermarket, it allows investors to trade securities freely without interference from those who issue them., but the returns on the investment are also considerably higher, which makes derivative trading a notch above.
Despite the various advantages and the importance of the global derivatives market mentioned above, there are a few factors from the other end of the spectrum that prove to be a hassle for players in the market. Let us understand the disadvantages through the explanation below.
- Risk: Since the underlying securities are traded in the open market, the fluctuation of prices poses a significant threat to the investor’s profitability.
- Time Factor: The market is contract-based. The investor has a heavy pressure of time to ensure profitability because, after the expiration date of the contract, it becomes null and void.
- Complex Nature: Most investors with limited knowledge find it extremely difficult to operate in this market. As a result, scammers and frauds find it easier to prey on these investors and make gains.
- Expertise: Unlike other securities, derivatives require a certain level of expertise, experience, and market exposure. Due to high requirements, most players do not venture into this section of the market, and even if they do, it takes quite some time to do well.
Frequently Asked Questions (FAQs)
While the stock market involves buying and selling of shares of individual companies, the derivatives market focuses on trading financial instruments that derive their value from underlying assets. Derivatives allow investors to gain exposure to asset prices without directly owning the assets.
Market participants in the derivatives market include hedgers, speculators, arbitrageurs, and market makers. Hedgers use derivatives to manage risk, speculators seek to profit from price movements, arbitrageurs exploit price discrepancies, and market makers provide liquidity and facilitate trading
The derivatives market enhances market stability by allowing participants to hedge their risk exposure and protect against adverse price movements. It also improves market efficiency by providing opportunities for price discovery, facilitating capital allocation, and enabling investors to gain exposure to a wide range of assets and strategies.
This has been a guide to what is the Derivatives Market and its meaning. Here we explain its types, importance, advantages, disadvantages, and examples. You can learn more about from the following articles –