Introduction:
A derivative is a financial instrument that derives its value from the performance of its underlying security/asset. The underlying security/asset could be anything like stocks and bonds, interest rate, currency, commodity, etc.
There are primarily two kinds of markets: cash markets or spot markets and derivative markets.
There are few instruments that also derive their value from the underlying securities but are not classified as the derivative instruments. For example, mutual funds and exchange-traded funds also derive their value from the underlying securities comprising them.
The major difference between the derivatives and the mutual funds is that the derivatives transform the performance of the underlying asset whereas the mutual funds and ETFs simply pass through the returns of their underlying securities.
Derivatives are similar to the insurance contracts as both instruments help in transferring of risk between two parties. A put option with an underlying instrument is also equivalent to an insurance contract. Derivatives also have a defined maturity similar to the insurance contracts.
Similar to all other financial instruments, derivatives require two parties for the trading to happen- long and short party.
Exchange-traded derivatives markets and Over-the-counter derivatives markets:
Some types of derivative instruments are traded in exchange-traded markets whereas the others trade in the over-the-counter markets. Few derivative instruments trade in both exchange-traded and over-the-counter markets.
Exchange-traded derivatives markets: These markets are standardized markets and the exchange specifies the terms and conditions. The exchange fixes the expiration date of the derivatives instrument, lot size, settlement process, and also specifies the underlying instruments on which the derivatives instrument can be created. The standardization of the derivative markets makes the instruments more liquid.
Both dealers (market makers) and speculators trade in the derivatives markets. The dealers hope to make a small profit by buying and selling the derivatives instruments simultaneously (a process known as scalping) at different prices. The speculators hold positions for a longer period in the hope of earning a profit from their positions.
The exchange does the process of clearing (verification of the execution of a transaction and recording the identities of the parties involved) and settlement (the exchange of money from one party to another). Derivatives exchanges clear and settle all contracts overnight whereas the security exchanges require two business days.
Standardization process leads to a loss of flexibility as almost everything is fixed, but it leads to more transparency. The exchanges also provide the credit guarantee by acting as a counterparty for every trade. They ask for depositing the money in the margin account as collateral for the performance.
OTC derivatives markets: These are customized markets and are thus more flexible. The dealers typically run these markets. The dealers hedge their risks by engaging in an alternative transaction that passes the risk on to the other parties. The dealers have special knowledge about how to hedge their risks and considered as a middleman. The OTC markets are informal markets as the dealers are not obligated to buy and sell the derivatives instruments. They do their job to earn a profit. OTC markets are not necessarily less liquid than the exchange-traded markets.
OTC markets have a lower degree of regulation. These markets used to be almost unregulated before 2010. The regulations have increased in the OTC markets after 2007 financial crisis. Now OTC transactions are usually cleared through central clearing agencies, and the transactions also need to be reported to regulators and are more closely monitored.
The primary differences between the two markets are summarized in the table below:
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Exchange-traded derivatives markets
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Over-the-counter derivatives markets
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These derivative markets are standardized.
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These derivative markets are customized.
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Less flexibility
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More flexibility
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Margin money is needed
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No margin money is required
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More regulations
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Less regulations
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No credit risk and the exchange acts as counterparty
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Some credit risk and the counterparty is just another party in the trade
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Check your concepts:
(57.1) Which of the following statements is least accurate about the OTC derivatives?
(a) These instruments are more flexible than the exchange-traded derivatives
(b) Margin money is generally not required in OTC derivatives
(c) These instruments are more liquid than the exchange-traded derivatives
(57.2) How many days are required for clearing and settlement by derivative exchanges for exchange-traded derivatives contracts?
(a) The clearing happens overnight and it takes two days for settlement
(b) Both clearing and settlement take two days
(c) Both clearing and settlement happen overnight
Solutions:
(57.1) Correct Answer is C: The exchange-traded derivatives are more liquid.
(57.2) Correct Answer is C: The clearing and settlement happen overnight in derivatives exchanges while it takes two days for settlement for security exchanges.
Next LOS: Forward commitments and contingent claims
