Basics of Derivatives

Types of Derivative Markets

We have learned the different types of derivative contracts but these are traded at different marketplaces. Let us discuss what they are.

There are 2 types of Derivative Markets.

Over the counter trades (OTC)
Exchange traded contracts.

Over the Counter Market

The OTC is a market where financial instruments such as currencies, stocks and commodities are traded directly between two parties, through a dealer network. Agreements on what, how many, for what price and under what conditions, are all made based on mutual consent. The contracts between two parties are tailor made and customized. They meet specific requirements of dealing with counterparties. OTCs are mostly traded for smaller companies that do not meet the criteria for a listing on the stock exchanges.

In an OTC trade, there doesn’t exist any, formal rules or mechanisms for risk management to ensure market stability and integrity. Management of counter-party risk is decentralized and located within individual institutions. Hence OTC trades have high Counterparty risk, due to which the volume in these markets are quite low.

Exchange Traded Contracts

Exchange traded contracts are those derivative contracts which takes place between two parties via a recognized exchange. Simply put, these are derivatives that are traded in a regulated fashion. Exchange traded derivatives have become increasingly popular because of the advantages they have over over-the-counter derivatives, such as standardization, and elimination of default risk.

Let us understand, what is Standardization?

The exchange has standardized terms and specifications for each derivative contract, with respect to quantity, and quality- making it easy for the investor to determine how many contracts can be bought or sold.

Suppose a person wants to trade in Gold futures at MCX exchange. So, the exchange specifies that the contract of 1 unit of gold is of 1kg and the purity factor of Gold is 995. Any other quantity or quality variation is not allowed at the exchange.

Talking of Default risk, lets know how is it eliminated in exchange traded contracts.

The derivatives exchange itself acts as the counterparty for each transaction involving an exchange traded derivative, effectively becoming the seller for every buyer, and the buyer for every seller. This eliminates the risk that the counterparty to the derivative transaction may default on its obligations.

Exchange traded derivatives have a mark-to-market feature. The gains and losses on every derivative contract are calculated on a daily basis. If the client has incurred losses, he or she will have to replenish the required capital in a timely manner or else the exchange squares up the position.

Because of the standardization feature and sound risk management policies, the exchange traded contracts have high liquidity, which makes it easier for the traders to trade, hence attracting more volume. There are various types of derivatives contract Forwards, Future, Options and Swaps.

Future and Options are exchange traded contracts whereas Forward and Swaps are OTC contracts.

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