Derivatives

What are derivatives?

Derivatives are powerful financial tools whose value comes from an underlying asset's performance - the primary instrument- , such as stocks, bonds, commodities, currencies, interest rates, or market indices. They are agreements set between two or more parties that can be traded on an exchange or over the counter (OTC).

Having no intrinsic value, derivatives derive their worth from changes in the underlying asset. They're used to hedge risks, speculate on price movements, or access otherwise difficult markets. Derivatives can move risk levels (and the accompanying rewards) from the risk-averse to the risk-seekers.

Why use derivatives?

1. Hedging: One of the most important uses is to reduce risk. For instance, a company expecting to receive payments in foreign currency may use derivatives to lock in an exchange rate.
2. Speculation: Traders often use derivatives to bet on the direction of market movements. While this can lead to big gains, it can also result in substantial losses.
3. Market Access: Sometimes, derivatives are the only practical way to gain exposure to certain markets or asset classes, especially when direct investment is restricted or inefficient.

Types of Derivatives

There are two classes of derivative products: lock and option. Lock products are noncontingent claims (e.g., futures, forwards, or swaps) that bind the respective parties from the outset to the agreed-upon terms over the life of the contract. Option products are contingent claims (e.g., stock options); on the other hand, they offer the holder the right, but not the obligation, to buy or sell the underlying asset or security at a specific price on or before the option’s expiration date.

1. Futures Contracts These are standardized agreements to buy or sell an asset at a predetermined price on a set future date. Futures are traded on exchanges and are commonly used for commodities like oil or wheat, as well as for financial instruments.
2. Forward Contracts Similar to futures, but these are private and customized agreements between two parties. They're traded over the counter (OTC), offering more flexibility but also introducing higher counterparty risk.
3. Options Options give the holder the right - but not the obligation -to buy or sell an asset at a specified price before a certain date. There are two main types: call options (for buying) and put options (for selling).
4. Swaps Swaps involve exchanging cash flows or other financial variables. A common example is an interest rate swap, where one party exchanges a fixed rate for a floating rate to manage exposure to interest rate fluctuations.

OTC and Exchange-Traded Derivatives

Derivatives can be traded in two primary ways:

• Over-the-Counter (OTC): They are privately negotiated contracts between two parties, offering high flexibility in terms, structure, and settlement. They're commonly used by institutions for customised risk management, but they also carry counterparty risk due to the absence of a central clearinghouse.

  • Market Tiers:

    • OTCQX is the top tier, featuring blue-chip stocks from countries like Europe, Canada, Brazil, and Russia. Companies must meet high financial standards, follow good governance, comply with U.S. laws, and maintain current disclosures.
    • OTCQB, the middle tier or "venture market," includes early-stage U.S. and international firms. Companies must be current in reporting, pass annual verification, meet a $0.01 bid test, and not be in bankruptcy.
    • OTC Pink is the lowest tier, with no reporting or SEC registration requirements. It includes both legitimate companies and high-risk entities such as shell companies.

  • Looser regulation means OTC markets can be riskier than national exchanges. Other risks of operating outside the full supervision of a formal exchange include less price transparency, fewer buyers and sellers, which can make exiting a position harder and lead to wider spreads, greater volatility, and the possibility that the other party to the transaction defaults and can’t make good on their side of the trade.

    Over-the-Counter (OTC) Markets: Trading and Securities

• Organised exchanges: Exchange-traded derivatives like futures and options are standardised contracts listed on regulated exchanges (e.g., NSE, CME), providing transparency, liquidity, and lower counterparty risk thanks to centralised clearing. While exchange-traded products suit traders seeking liquidity and lower credit risk, OTC contracts are preferred when bespoke solutions are needed.

  Exchange-Traded Derivative: Definition, Examples, Vs. OTC

Five Differences Between OTC and Exchange Traded Derivatives - HedgeStar

Futures