Question

Discuss the nature and purpose of derivative products. In your answer consider the different types of derivative products, the risks managed by these products and the differences between exchange-traded contracts and over-the-counter contracts.

Answer 1

* Nature of Derivative

  Derivatives are financial contracts whose value is linked to the value of an underlying asset. They are complex financial instruments that are used for various purposes, including hedging and getting access to additional assets or markets.The most common underlying assets for derivatives are stocks, bonds, commodities, currencies, interest rates, and market indexes. These assets are commonly purchased through brokerages. Most derivatives are not traded on exchanges and are used by institutions to hedge risk or speculate on price changes in the underlying asset.

* Purpose of derivative

price discovery of the assets depend on a continuous flow of information from around the world.

They improve Market efficiency for the Underlying Asset.

Derivative are used to hedge the risk and speculate the future trends.

* Types of Derivative Products

Forwards and futures

These are financial contracts that obligate the contracts’ buyers to purchase an asset at a pre-agreed price on a specified future date. Both forwards and futures are essentially the same in their nature. However, forwards are more flexible contracts because the parties can customize the underlying commodity as well as the quantity of the commodity and the date of the transaction. On the other hand, futures are standardized contracts that are traded on the exchanges.

Options

Options provide the buyer of the contracts the right, but not the obligation, to purchase or sell the underlying asset at a predetermined price. Based on the option type, the buyer can exercise the option on the maturity date (European options) or on any date before the maturity (American options).

Swaps

Swaps are derivative contracts that allow the exchange of cash flows between two parties. The swaps usually involve the exchange of a fixed cash flow for a floating cash flow. The most popular types of swaps are interest rate swaps, commodity swaps, and currency swaps.

Difference Between exchange traded and Over-the-counter contracts

1)  An exchange traded product is a standardized financial instrument that is traded on an organized exchange.

An over the counter (OTC) product or derivative product is a financial instrument traded off an exchange.

2) Exchange traded contracts are standardized and the OTC contracts are customized.

3) Exchange traded contracts are regulated and OTC contracts are not regulated.