Derivatives are a class of financial instruments which derive their value from the performance of basic underlying assets. Equities, fixed income instruments, currencies, and commodities are all basic assets which are said to trade in cash or spot markets at cash or spot prices.
The widely used definition of derivative is that they derive their performance from underlying assets. However, this definition could apply to exchange-traded funds (ETFs) or even mutual funds. A better distinction would be to say derivatives usually transform the performance of the underlying asset. Derivatives are similar to insurance in that they allow for the transfer of risk from one party to another. The risk itself does not change, but the party bearing the risk does. It is the underlying asset that is the source of the risk, referred to as the “underlying” – which does not necessarily have to be an asset. The underlying could include interest rates, credit, energy, weather and even other derivatives in addition to more traditional assets.
Derivatives are created in the form of legal contracts involving two parties, the buyer, and the seller. The seller is sometimes known as the writer. The buyer, who purchases the derivative, is referred to as the “long” or the holder while the seller (writer) is referred to as the “short”. The derivative contract always defines the rights and obligations of each party and these are recognized by a legal system.
Classes of Derivatives
There are two classes of derivatives, forward commitments, and contingent claims. Forward commitments provide the ability to lock-in a future price in the form of a forward contract, futures contract or swap. A contingent claim is an option. It provides for the right but not the obligation to transact at a pre-determined price.
Benefits of Derivatives
Derivatives can be used to implement strategies that cannot be achieved with their underlying’s alone. Derivatives have as an inherent feature a high degree of leverage. This means that investors typically only commit small amounts of money to a derivative position relative to the equivalent position in the underlying asset. Small movements in the underlying can lead to large movements in the derivative – both positive and negative. Derivatives generally trade at low transaction costs in liquid markets.
There are numerous applications in the practice of risk management where the use of derivatives provides a useful tool for managing exposure to particular risks.
The Derivative Market
Derivatives can trade on organized exchanges like the New York Stock Exchange or the Tokyo Stock Exchange, or they can trade over-the-counter (OTC). Increasingly, there is less distinction between exchange-traded and OTC markets as exchanges move towards fully electronic systems.
The key feature of exchange-traded derivative contracts is the standardization of the contracts. This means the terms and conditions are precisely specified by the exchange. This specification applies to features like the schedule of expiry dates and contract magnitude. The market participants in the exchange-traded derivatives markets are the market-makers (dealers) and speculators who are typically members of the exchange. The interplay between market makers and speculators creates a more liquid and more orderly market.
The standardization also ensures clearing (verification of transaction and identities) and settlement (transfer of money) of derivatives contracts happens efficiently and allows for the provision of a credit guarantee by the clearing house. The clearinghouse is able to provide this guarantee through the requirement of a cash deposit called a margin bond or performance bond.
Exchange traded markets are said the have transparency as full information on the transactions is disclosed to the exchange and regulatory bodies. This does mean a loss of privacy and coupled with the standardization, a loss of flexibility. As an alternative to standardization, OTC markets provide an alternative.
The OTC derivative market is made up of a number of informal participants, the backbone of which are typically banking dealers leading to the OTC market sometimes being referred to as a dealer market. Dealers are not obligated to participate which makes the market an informal one.
As OTC derivative contracts are not standardized, risk management activities become more complicated. It can be difficult for a dealer to find a contract which is a perfect match to hedge a position and they usually have to rely on similar transactions in which they can lay off their risk. The ability to customize OTC contracts does not necessarily make the market less liquid than the standardized exchange-traded contracts. As many of the OTC instruments can be easily created, an offsetting instrument can be created, oftentimes between the same two transacting parties to terminate the position.
OTC markets do have a lower level of regulation than exchange-traded markets. However, post the 2007 financial crisis, regulatory oversight has been increasing and on full implementation of new rules, a number of OTC transactions will have to be cleared through central clearing agencies with information reported to the regulatory authorities.
Which statement best describes the OTC derivatives market?
A. Contracts are standardized and typically cleared and settled through a centralized clearing house.
B. Contracts are flexible and there is a high degree of reporting to the regulatory authorities.
C. Contracts are flexible, often cleared and settled between transacting parties with a low level of regulatory oversight.
The correct answer is C.
Exchange-traded derivative contracts are standardized, cleared and settled through a centralized clearinghouse and accompanied by a high level of regulatory reporting. OTC contracts are far more flexible and less regulated.
Reading 56 LOS 56a:
Define a derivative and distinguish between exchange-traded and over-the-counter derivatives