Derivative Market and the Meaning of Derivative Market

Mehraj Mattoo (1997), Structured Derivatives: New Tools for Investment Management A Handbook of Structuring, Pricing & Investor Applications (Financial Times)

The Derivatives Market is meant as the market where exchange of derivatives takes place. Derivatives are one type of securities whose price is derived from the underlying assets. And value of these derivatives is determined by the fluctuations in the underlying assets. These underlying assets are most commonly stocks, bonds, currencies, interest rates, commodities and market indices. As Derivatives are merely contracts between two or more parties, anything like weather data or amount of rain can be used as underlying assets. The Derivatives can be classified as Future Contracts, Forward Contracts, Options, Swaps and Credit Derivatives.

For example, a call option on the stock of Coca-Cola is a derivative security that obtains value from the shares of Coca-Cola that can be purchased with the call option. Call options, put options, convertible bonds, futures contracts, and convertible preferred stock are examples of derivatives. A derivative can be either a risky or low-risk investment.

The need for a derivatives market

The derivatives market performs a number of economic functions:

1. They help in transferring risks from risk averse people to risk oriented people

2. They help in the discovery of future as well as current prices

3. They catalyze entrepreneurial activity

4. They increase the volume traded in markets because of participation of risk averse

people in greater numbers

5. They increase savings and investment in the long run

Derivatives are used by investors to:

provide leverage (or gearing), such that a small movement in the underlying value can cause a large difference in the value of the derivative;

speculate and make a profit if the value of the underlying asset moves the way they expect (e.g., moves in a given direction, stays in or out of a specified range, reaches a certain level);

hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out;

obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather derivatives);

create option ability where the value of the derivative is linked to a specific condition or event (e.g., the underlying reaching a specific price level).

Derivative Market and Financial Risk

Derivatives play a vital role in risk management of both financial and non-financial institutions. But, in the present world, it has become a rising concern that derivative market operations may destabilize the efficiency of financial markets. In today's' world the companies the financial and non-financial firms are using forward contracts, future contracts, options, swaps and other various combinations of derivatives to manage risk and to increase returns. It is true that growth of derivatives market reveal the increasing market demand for risk managing instruments in the economy. But, the major concern is that, the main components of Over the Counter (OTC) derivatives are interest rates and currency swaps. So, the economy will suffer surely if the derivative instruments are misused and if a major fault takes place in derivatives market.

Types of Derivative Market

The Derivative Market can be classified as Exchange Traded Derivatives Market and Over the Counter Derivative Market.

Exchange Traded Derivatives are those derivatives which are traded through specialized derivative exchanges whereas Over the Counter Derivatives are those which are privately traded between two parties and involves no exchange or intermediary. Swaps, Options and Forward Contracts are traded in Over the Counter Derivatives Market or OTC market.

The main participants of OTC market are the Investment Banks, Commercial Banks, Govt. Sponsored Enterprises and Hedge Funds. The investment banks markets the derivatives through traders to the clients like hedge funds and the rest.

In the Exchange Traded Derivatives Market or Future Market, exchange acts as the main party and by trading of derivatives actually risk is traded between two parties. One party who purchases future contract is said to go "long" and the person who sells the future contract is said to go "short". The holder of the "long" position owns the future contract and earns profit from it if the price of the underlying security goes up in the future. On the contrary, holder of the "short" position is in a profitable position if the price of the underlying security goes down, as he has already sold the future contract. So, when a new future contract is introduced, the total position in the contract is zero as no one is holding that for short or long.

The trading of foreign exchange traded derivatives or the future contracts has emerged as very important financial activity all over the world just like trading of equity-linked contracts or commodity contracts. The derivatives whose underlying assets are credit, energy or metal, have shown a steady growth rate over the years around the world. Interest rate is the parameter which influences the global trading of derivatives, the most.

Types of derivatives

OTC and exchange-traded

In broad terms, there are two groups of derivative contracts, which are distinguished by the way they are traded in the market:

Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds. Reporting of OTC amounts are difficult because trades can occur in private, without activity being visible on any exchange. According to the Bank for International Settlements, the total outstanding notional amount is US$684 trillion (as of June 2008). Of this total notional amount, 67% are interest rate contracts, 8% are credit default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are other. Because OTC derivatives are not traded on an exchange, there is no central counter-party. Therefore, they are subject to counter-party risk, like an ordinary contract, since each counter-party relies on the other to perform.

Exchange-traded derivative contracts (ETD) are those derivatives instruments that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where individuals trade standardized contracts that have been defined by the exchange. A derivatives exchange acts as an intermediary to all related transactions, and takes Initial margin from both sides of the trade to act as a guarantee. The world's largest derivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products), and CME Group (made up of the 2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade and the 2008 acquisition of the New York Mercantile Exchange). According to BIS, the combined turnover in the world's derivatives exchanges totaled USD 344 trillion during Q4 2005. Some types of derivative instruments also may trade on traditional exchanges. For instance, hybrid instruments such as convertible bonds and/or convertible preferred may be listed on stock or bond exchanges. Also, warrants (or "rights") may be listed on equity exchanges. Performance Rights, Cash xPRTs and various other instruments that essentially consist of a complex set of options bundled into a simple package are routinely listed on equity exchanges. Like other derivatives, these publicly traded derivatives provide investors access to risk/reward and volatility characteristics that, while related to an underlying commodity, nonetheless are distinctive

Common types of derivatives

Derivatives are a tool used by investors to manage risk. It is a complex area and one that requires a great deal of study and application to master. In brief, a derivative gets its value from another financial product. There are two primary types of derivative contracts: over-the-counter (OTC) derivatives and exchange-traded derivatives. They differ from each other in the ways they are traded on the market. There are also three major classes of derivatives: some types of warrants, futures and exchange-traded options.

Futures. (Also sometimes called "forwards") are contracts that say an asset block will be sold or bought on an agreed future date

Futures are contracts to buy or sell an asset on or before a future date at a price specified today. A futures contract differs from a forward contract in that the futures contract is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold, whereas a forward contract is a non-standardized contract written by the parties themselves.

Options. An option gives the contract holder the right to buy or sell on a specified date in the future - but they are under no obligation to take up this "option".

Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an asset. The price at which the sale takes place is known as the strike price, and is specified at the time the parties enter into the option. The option contract also specifies a maturity date. In the case of a European option, the owner has the right to require the sale to take place on (but not before) the maturity date; in the case of an American option, the owner can require the sale to take place at any time up to the maturity date. If the owner of the contract exercises this right, the counter-party has the obligation to carry out the transaction.

Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets.

Swaps:

Swaps are private agreements between two parties to exchange cash flows

in the future according to a prearranged formula. They can be regarded as

portfolios of forward contracts. The two commonly used swaps are:

A· Interest rate swaps: These entail swapping only the interest related cash

flows between the parties in the same currency.

A· Currency swaps: These entail swapping both principal and interest

between the parties, with the cash flows in one direction being in adifferent currency than those in the opposite direction.

Warrants. A tool used for trading on the stock exchange. They can be held over shares, currency, an index or commodity. Warrants (and options) allow the holder to earn additional income from their shares or to protect value of their existing assets.

Types of options

In Australia the different kinds of options available to investors include:

Flex options

Long term options

Low exercise price options (LEPOs)

Index options

Index LEPOs

Types of warrants

There are also a range of different kinds of warrants commonly in use. They are:

Equity call and put warrants

Installment warrants

Endowment warrants

Low exercise price warrants

Options are traded electronically by brokers on a computerised market called the Derivatives Trading Facility (DTF). Using this system the first order placed is the first order processed and at the end of the day any unexercised orders lapse. Warrants are traded using the ASX share trading system.

The Australian Stock Exchange is a fantastic resource for further information about derivatives and also runs education classes for new investors. Alternatively, have look through the Investor Buddy Learning Centre or Derivatives section or email us.

Benefits

The use of derivatives also has its benefits:

Derivatives facilitate the buying and selling of risk, and many people.consider this to have a positive impact on the economic system. Although someone loses money while someone else gains money with a derivative, under normal circumstances, trading in derivatives should not adversely affect the economic system because it is not zero sum in utility.

Former federal reserver board chairman Alan Greenspan commented in 2003 that he believed that the use of derivatives has softened the impact of the economic downturn at the beginning of the 21st century.

Government regulation

In the context of a 2010 examination of the ICE Trust, an industry self-regulatory body, the chairman of the Commodity Futures Trading Commission which regulates most derivatives, was quoted saying that the derivatives marketplace as it functions now "adds up to higher costs to all Americans." More oversight of the banks in this market is needed, he also said. Additionally, the report said, "the Department of Justice is looking into derivatives, too. The department's antitrust unit is actively investigating 'the possibility of anticompetitive practices in the credit derivatives clearing, trading and information services industries,' according to a department spokeswoman."

Definitions

Bilateral netting:

A legally enforceable arrangement between a bank and a counter-party that creates a single legal obligation covering all included individual contracts. This means that a bank's obligation, in the event of the default or insolvency of one of the parties, would be the net sum of all positive and negative fair values of contracts included in the bilateral netting arrangement.

Credit derivative:

A contract that transfers credit risk from a protection buyer to a credit production seller. Credit derivative products can take many forms, such as credit default swaps, credit linked notes and total return swaps.

Derivative:

A financial contract whose value is derived from the performance of assets, interest rates, currency exchange rates, or indexes. Derivative transactions include a wide assortment of financial contracts including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards and various combinations thereof.

Exchange-traded derivative contract:

Standardized derivative contracts that are transacted on an organized futures exchange.

Gross negative fair value:

The sum of the fair values of contracts where the bank owes money to its counter-parties, without taking into account netting. This represents the maximum losses the bank's counter-parties would incur if the bank defaults and there is no netting of contracts, and no bank collateral was held by the counter-parties.

Gross positive fair value Gross:

The sum total of the fair values of contracts where the bank is owed money by its counter-parties, without taking into account netting. This represents the maximum losses a bank could incur if all its counter-parties default and there is no netting of contracts, and the bank holds no counter-party collateral.

High-risk motgage securities:

Securities where the price or expected average life is highly sensitive to interest rate changes, as determined by the FFIEC policy statement on high-risk mortgage securities.

Notional amount:

The nominal or face amount that is used to calculate payments made on swaps and other risk management products. This amount generally does not change hands and is thus referred to as notional.

Over-the-counter (OTC) derivative contracts:

Privately negotiated derivative contracts that are transacted off organized futures exchanges.

structured notes:

Non-mortgage-backed debt securities, whose cash flow characteristics depend on one

or more indices and / or have embedded forwards or options.

Conclusions

In terms of the growth of derivatives markets, and the variety of derivatives users, the Indian market has equalled or exceeded many other regional markets. While the growth is being spearheaded mainly by retail investors, private sector institutions and large corporations, smaller companies and state-owned institutions are gradually getting into the act. Foreign brokers such as JP Morgan Chase are boosting their presence in India in reaction to the growth in derivatives. The variety of derivatives instruments available for trading is also expanding.

There remain major areas of concern for Indian derivatives users. Large gaps exist in the range of derivatives products that are traded actively. In equity derivatives, NSE figures show that almost 90% of activity is due to stock futures or index futures, whereas trading in options is limited to a few stocks, partly because they are settled in cash and not the underlying stocks. Exchange-traded derivatives based on interest rates and currencies are virtually absent.

Liquidity and transparency are important properties of any developed market. Liquid markets require market makers who are willing to buy and sell, and be patient while doing so. In India, market making is primarily the province of Indian private and foreign banks, with public sector banks lagging in this area (FitchRatings, 2004). A lack of market liquidity may be responsible for inadequate trading in some markets. Transparency is achieved partly through financial disclosure. Financial statements

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