Financial markets/Financial markets : Derivatives Market

Overview

• Derivatives are financial products used by investors to manage risks and to limit losses due to fluctuations in interest and exchange rates, in the price of securities, in commodities prices and in other financial instruments. Derivatives are also used in financial and investment management and are an object of speculation.

• The value of derivatives varies with the price of the underlying assets. The most common types of derivative are forwards and futures, options, and swaps. Forwards and futures contracts are commitments to exchange the underlying asset in an agreed upon quantity, for an agreed upon price at specified future time. An options contract conveys to the holder the advance option to buy (or sell) the underlying assets at the price, time and quantity specified in the contract. A swap is an agreement to exchange cash flows over a period of time. The two major types of swap are interest rate swaps and foreign currency swaps.

• Derivatives are either exchange-traded derivatives (ETD) or over-the-counter traded (OTC). ETD and OTC derivatives differ, for example, in types of contract, degree of standardization, monetary guarantees, trading liquidity, investment risk and delivery and payment procedures. OTC is the more popular channel as it allows greater flexibility in tailoring the contract to the wishes of the parties. On the other hand, the more standardized ETD contracts are more negotiable on the market, that is, they have more trading liquidity.