Derivatives are a type of financial instrument that depends on the value of another asset, such as a share, a commodity, a currency, or an interest rate. Investors can use derivatives for different reasons, such as reducing risk, making a profit, or taking advantage of price differences.

Derivatives can be classified into two main categories: Over-the-Counter (OTC) and exchange-traded. OTC derivatives are contracts agreed upon privately by two parties, while exchange-traded derivatives are standardised contracts traded on a regulated market.

This blog will explore exchange-traded derivatives, their characteristics, benefits, and examples.

Features of exchange-traded derivatives

Exchange-traded derivatives have some standard features that distinguish them from OTC derivatives. These include:

• Standardisation: Each derivative contract on the exchange has fixed terms and conditions, such as the price, date, type, asset, and quantity. This makes it convenient for investors to compare and trade different contracts.

• Liquidity: The exchange offers a market for buyers and sellers to exchange derivatives. This ensures a high level of liquidity and price formation for the contracts. Investors can easily buy and sell their positions at any time during the market hours.
• Clearing: The exchange serves as the intermediary for every trade and ensures the execution of the contracts. This eliminates the default risk or the risk that one party may not honour its obligations. The exchange also clears the trades through a clearinghouse, which holds and manages the margin money from both parties.
• Regulation: The exchange and its derivatives products are supervised by the relevant authorities, such as the Securities and Exchange Board of India (SEBI) in India. This ensures transparency, integrity, and compliance with the rules and regulations.

Advantages of exchange-traded derivatives

Exchange-traded derivatives offer the following benefits:

• Lower cost: These derivatives are cheaper to trade than OTC derivatives, as they do not need any middlemen or brokers. The exchange only charges a small fee for each trade, which is usually part of the bid-ask spread.
• Higher leverage: Exchange-traded derivatives allow investors to take larger positions with less capital, requiring only a fraction of the contract value as margin. This magnifies the potential returns as well as the risks of the trade.
• Diversification: These derivatives allow investors to diversify their portfolios and access various financial assets, such as commodities, equities, currencies, and interest rates. Investors can also use derivatives to reduce risk to the underlying asset or create artificial positions.

Examples of exchange-traded derivatives

Some of the most popular exchange-traded derivatives are:

• Futures: A futures contract is an arrangement to buy or redeem an underlying asset at a set price and date in the future. Futures contracts are uniform and traded on markets such as the National Stock Exchange (NSE) or the Multi Commodity Exchange (MCX) in India. Futures can be used to protect against price changes or to bet on the market's future direction.
• Option: These contracts offer buyers the choice to purchase or redeem an underlying asset at a specific price and date in the future without any obligation. The seller, or the writer, of the option gets a premium from the buyer for giving this option. Options contracts are also uniform and traded on markets like the NSE or the Bombay Stock Exchange (BSE) in India. Options can be utilised to guard against downside risk or create various strategies with risk-reward profiles.

• Swaps: A swap contract is a deal to swap cash flows based on different reference rates or prices of an underlying asset. Swaps are usually OTC derivatives, but some standardised swaps are traded on markets such as the NSE or the BSE in India. Swaps can be used to protect against interest rate or currency risk or to take advantage of arbitrage opportunities.

Conclusion

Exchange-traded derivatives are financial contracts listed and traded on a regulated exchange. They have advantages over OTC derivatives, such as standardisation, liquidity, clearing, and regulation. Exchange-traded derivatives can be used for various purposes, such as hedging, speculation, or arbitrage. Common examples of exchange-traded derivatives are futures, options, and swaps.

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