Derivative contracts get their value from the price changes of the assets they're based on, and these assets can be pretty much anything, like stocks, commodities, real estate, currencies, or indices. There are two main types: Exchange Traded Derivatives, which follow standardised rules, and over-the-counter derivatives, which involve private deals between parties. In this article, let's understand in detail about Exchange Traded Derivatives.
A derivative is a financial contract whose value is derived from the price fluctuation of its underlying asset, such as stocks, currencies, bonds, commodities, etc. There are two types of derivatives: one that is traded in the stock markets under standardised terms and conditions, called Exchange Traded Derivatives. And the other is traded between private counter-parties without an intermediary, known as an Over the Counter (OTC).
Exchange Traded Derivatives are standardised financial contracts that are traded on stock exchanges in a regulated manner. Market regulators like the Securities and Exchange Board of India (SEBI) draft rules for them. In comparison to OTC derivatives, ETDs have a few advantages, like uniform rules and no default risk.
Exchange traded derivatives are becoming increasingly popular because of their features, including:
A major differentiating factor of ETD is the standardisation of contracts. Each Exchange traded derivative contract has a predetermined expiration date, lot size, settlement process, and other rules and regulations. In turn, this makes it easier for the Exchange to provide specialised contracts to buyers and sellers.
ETDs are transactions between parties through an intermediary rather than between them directly. In this way, the counterparty risk is eliminated. As the intermediary, the Exchange is a credible counterparty. Because both parties are contractually obligated to the intermediary, there are fewer chances of default.
ETDs are characterised by a high level of liquidity. Because of this, traders are easily able to reverse their positions by connecting with their counterparts and making opposite bets against or selling their stakes. Due to the liquid market, these parties can be easily found and traded, resulting in the stake being sold without any significant loss.
Because traders can offset any previous contracts, ETD can be purchased from the market with ease. There are two ways to settle an ETD without much hassle: selling the current position out in the market and purchasing an offset position at a revised price.
Since the Exchange is an unbiased body with many regulations, ETD is safer in nature. Additionally, it prevents the big players from cornering the market and gaining complete control over the commodity.
After seeing ETD in detail, let's explore their types.
The most common exchange traded derivative is stock. They are further available in different forms, like stock options and stock forwards. With these stocks, it is possible to take highly leveraged positions on price movements. In India, only the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) deal in stock derivatives. To direct the future movement of stocks, stock derivatives are considered the most important derivatives.
Some investors prefer to trade an entire group of stocks that make up an exchange, rather than dealing with individual stock futures. These groups of stock-related derivatives are known as Index Exchange Traded Derivatives (ETDs).
The key difference between stock and index ETDs is that you can physically receive the stock derivatives, meaning you can get them in cash. For example, if you have a TCS stock derivative, you could get paid with TCS shares. However, with index derivatives, like the BSE index, there's no physical delivery involved.
Some commonly traded index derivatives include well-known ones like Nifty 50, Sensex, Nikkei, Nasdaq, S&P 500, and more.
A commodity is usually a raw material. As underlying assets for futures and options, standardised contracts include physical assets and commodities such as gold, silver, crude oil, zinc, etc. MCX is India's major commodity exchange for trading commodity derivatives.
Currency Exchange Traded Derivatives are also available for trading. These ETDs are linked to different currencies and offer a more regulated way of trading compared to the more flexible OTC (Over-the-counter) markets.
Investors can use currency ETDs to bet on the future movements of currency pairs. In the National Stock Exchange (NSE), for example, there are four currency pairs you can trade:
So, with currency ETDs, you can take both long and short positions on these specific currency pairs.
Through Exchange Traded Derivatives, investors can invest in real estate without having to own any buildings or corporate facilities. In 2008, they were at the centre of the global financial crisis. Although real estate ETDs are not as popular as they used to be, they remain traded in good volumes despite their diminished popularity. A niche knowledge of these instruments is necessary since they are complex and structured instruments.
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. After you've learned what ETD is, you can add them to your investment portfolio and make money. However, don't forget to choose a reputable and trusted advisor before investing in derivatives. Choose a broking firm that gives you multiple benefits, like a free Demat account and trading account opening offer by Kotak Securities.
The exchange-traded derivative market is standardised, regulated, and settled through clearing houses, while the over-the-counter derivatives market is customised, negotiated privately, and involves counterparty risk.
These investments are understandable, reliable, and liquid, which appeals to investors. The features of the contract are clear. Contracts must be abided by both parties. The risk of default is eliminated. The exchanges are regulated. In turn, trust in financial markets leads to liquidity, which in turn leads to efficient pricing and access.
Exchange trading includes stock options, currency futures, options and swaps, and index futures.
Compared to over-the-counter (OTC) derivatives, exchange-traded derivatives offer more liquidity, transparency, and lower counterparty risk. Options on futures contracts, futures, and options on futures are all exchange-traded derivatives.
Exchange traded markets are centralised markets where an intermediary acts as a central organiser.
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