Exchange-Traded Derivative: Definition, Examples, Vs OTC

In the United States, after the financial crisis of 2007–2009, there has been increased pressure to move derivatives to trade on exchanges. 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. 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. These contracts can be used to trade any number of assets and carry their own risks. These financial securities are commonly used to access certain markets and may be traded to hedge against risk.

A derivative is set between two or more parties that can trade on an exchange or over-the-counter (OTC). Forward contracts are typically used by investors who want to limit their risk to exchange rate volatility. For example, if you’ve sold goods to someone and agreed to get paid six months in the future, you might choose to enter a forward contract.

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. 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. The term derivative refers to a type of financial contract whose value is dependent on an underlying asset, group of assets, or benchmark.

To direct the future movement of stocks, stock derivatives are considered the most important derivatives. The development of foreign exchange derivatives market was in the 1970s with the historical background and economic environment. Firstly, after the collapse of the Bretton Woods system, in 1976, the International Monetary Fund held a meeting in Jamaica and reached the Jamaica agreement.

The offsetting transactions can be performed in a matter of seconds without needing any negotiations, making exchange-traded derivatives instruments significantly more liquid. 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.

Derivatives trading refers to the buying and selling of derivative contracts. Derivative contracts are essentially time-bound financial instruments with a fixed expiry date. 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.

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. Derivatives today are based on a wide variety of transactions and have many more uses.

• In the Indian markets, futures and options are standardized contracts, which can be freely traded on exchanges.
• The derivatives market in India is highly leveraged, so the opportunities of making money are typically much higher than traditional share trading.
• Exchange-traded derivatives can be used to hedge exposure and to speculate on a wide range of financial assets, including commodities, equities, currencies, and even interest rates.
• 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.

Some commonly traded index derivatives include well-known ones like Nifty 50, Sensex, Nikkei, Nasdaq, S&P 500, and more. Along with many other financial products and services, derivatives reform is an element of the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010. The Act delegated many rule-making details of regulatory oversight to the Commodity Futures Trading Commission (CFTC) and those details are not finalized nor fully implemented as of late 2012.

So, in India, there are stock derivatives, index derivatives, commodity derivatives, and currency derivatives. Since derivatives such as futures and options derive their value from underlying assets, they can drive the prices of those assets in the short term. For instance, when the number of people buying futures and call options with a particular stock as the underlying asset rises exponentially, it paints an optimistic view on the stock’s near-term price. This creates more demand and triggers investors to buy more shares of that stock in the cash segment, thereby increasing the stock prices. Derivative trading requires you to keep a specific percentage of the value of your outstanding derivative position (total value of your holdings) as cash in your trading account. You are required to hold this margin money to help minimise the risk exposure for the stock exchanges you’re trading on.

Any movement in the price of milk will be reflected in the price of the corresponding derivative which in this case is paneer. 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.

Exchange-traded derivatives have become increasingly popular because of the advantages they have over over-the-counter (OTC) derivatives. These advantages include standardization, liquidity, and elimination of default risk. It’s important to remember that when companies hedge, they’re not speculating on the price of the commodity. 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. To access NCDEX markets, you would need to have an account at an authorized broker who is connected to the exchange in India.

The level of exposure varies throughout the life of the contract and the extent of losses will only be known at the time of default. Entities which are market-makers in derivatives should maintain a unit which is responsible for monitoring and controlling the risks in derivatives. This unit should report directly to the board (or ALCO) or to senior management who are not directly responsible for trading activities. (i) For hedging (as defined in paragraph 4 above) underlying exposures (ii) Banks, PDs and AFIs can undertake FRA/ IRS to hedge the interest rate risk on any item(s) of asset or liability on their balance sheet. (iii) Banks may undertake interest rate futures transactions to hedge the interest rate risk on their investments in Government securities in AFS and HFT portfolios.

Now that you know what is ETD, you can add these to your investment portfolio and start making profits. Before investing in derivatives, do remember to select a trusted and reputed financial advisor. Opt for a broking firm that provides multiple benefits, like a free Demat account and crypto derivatives exchange trading account, an all-in-1 trading platform etc. like IIFL. The exchange-traded derivatives market allows you to trade a variety of derivative products through a standardised financial contract. As the stock exchange acts as a counterparty, it significantly mitigates default risk.