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 the individual as well as institutional investors.
Types of Derivatives Market
Depending on the terms and conditions and legal terms, this market can be divided into two parts, namely:
#1 – Exchange Traded Derivatives
They consist of derivative contracts 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:
Source: statista.com
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 expiry month are as below:
Example
A 2-Year U.S. Treasury Note has generic code as ‘TU’ so a 2-Year U.S. 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 Note 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 futures are a few derivatives to name a few that are traded on the exchange.
#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 counter, 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.
Example
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 as a forward contract. 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 options, the European swaptions can be exercised only at the expiration date. The same goes for American swaptions, like American options these can be exercised at any time the option holder finds the contract favorable to exercise.
Advantages of Derivatives Market
- 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 derivate 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 market but the returns on the investment are also considerably higher which makes derivative trading a notch above.
Important Points
- 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 decline 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 straight forward, derivative trading requires a sound knowledge of the market and the trends.
Conclusion
- 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.
- Derivative 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.
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