Definition
An Exchange Traded Derivative is a financial instrument whose value is derived from another asset and is bought and sold on regulated exchanges. These derivatives can include futures and options contracts that are standardized in terms of their underlying assets, quantity, quality, and delivery time. They provide liquidity and reduce risk because exchanges often act as counter-parties, eliminating counter-party risk.
Phonetic
The phonetics of “Exchange Traded Derivative” are:- Exchange : /ɪksˈtʃeɪnʤ/- Traded : /ˈtreɪdɪd/- Derivative : /dɪˈrɪvətɪv/
Key Takeaways
- Liquidity: Exchange Traded Derivatives (ETDs) are traded on a public exchange, increasing their liquidity. This makes them more accessible and easier to buy and sell than over-the-counter (OTC) derivatives.
- Standardization: ETDs are standardized contracts with transparent pricing, which can be appealing to investors. Standardization also elicits more efficient processing within financial systems.
- Reduced Counterparty Risk: With ETDs, the risk of one party defaulting on their obligations is significantly reduced due to the stringent regulation of the exchange. The exchange acts as the counterparty to both parties involved in the transaction, thus reducing the risk associated with the derivative.
Importance
Exchange Traded Derivatives are essential in the business/finance realm as they provide important functionalities such as risk hedging, discovery of future prices, and opportunity for speculative gains. Being standardized contracts traded on regulated exchanges, they provide investors with transparency, liquidity, and increased safety through regulations, unlike Over-The-Counter (OTC) derivatives. They are also marked-to-market daily which helps to decrease credit risk. The exchange’s clearing house acts as a counter-party on all contracts, giving investors additional assurance and reducing overall transaction risk. Thus, Exchange Traded Derivatives present a more secure and efficient environment for traders and investors.
Explanation
Exchange Traded Derivatives are utilized for various reasons in diverse fields, where they serve as potent tools for risk management, speculation, and enhanced returns. Particularly, they are quite significant in risk management, where they are employed by companies and individuals to hedge against different types of risks. For example, a crude oil producing firm might use future contracts to hedge against potential price drops, essentially “locking in” a future selling price. Similarly, portfolio managers or investors might use options contracts to buffer against potential losses in their investment portfolio, creating a safety net where only a small premium is at risk.In the realm of speculation and enhanced returns, Exchange Traded Derivatives are extensively used to multiply existing positions or bet on future movements in markets. For instance, day-traders might utilize futures contracts to leverage their positions and amplify potential gains (while also widening potential losses). Moreover, an investor might purchase options contracts to bet on the future movement of a security’s price, which, if correctly predicted, can yield significant gains for a relatively small initial investment. Consequently, Exchange Traded Derivatives, despite their unique complexities and risks, can serve as effective financial tools for a variety of purposes.
Examples
1. Stock Options: Stock options are one of the most common types of exchange traded derivatives. This contract gives the buyer the right, but not the obligation, to buy or sell a stock at a specific price within a specific time frame. For example, technology companies often use stock options as a form of compensation for their employees, where they have the right to buy company shares in the future at a set price today. 2. Futures Contracts: Commodities like oil, gold, and wheat are frequently traded through futures contracts. For instance, a farmer may use futures contracts to lock in a price ahead of the harvest season, mitigating the risk of price fluctuations. If the farmer expects a decrease in the price of wheat due to an increase in supply, they could sell futures contracts to protect against potential losses, effectively hedging their risk.3. Index Options: Similar to stock options, index options offer the buyer the right, but not an obligation to buy or sell an index at given price by a certain date. A real world example could be S&P 500 Index Options traded on the Chicago Board Options Exchange (CBOE). An investor who purchases an S&P 500 index option can control a large amount of value based on the S&P 500 index for a fraction of the cost, giving him the leverage to profit from changes in the index level.
Frequently Asked Questions(FAQ)
What is an Exchange Traded Derivative?
An Exchange Traded Derivative is a financial instrument that derives its value from an underlying asset and is bought or sold through regulated exchange platforms. These can include commodities, bonds, currencies, interest rates, market indexes and stocks.
What are some examples of Exchange Traded Derivatives?
Examples of Exchange-Traded Derivatives are futures and options. These instruments are standardized, regulated, and transparent.
How do Exchange Traded Derivatives differ from Over the Counter (OTC) derivatives?
Unlike OTC derivatives, Exchange Traded Derivatives are not traded directly between two parties. Instead, they are traded on an exchange platform which guarantees the performance of the contracts.
What applications do Exchange Traded Derivatives have in finance and business?
Exchange Traded Derivatives are mainly used for hedging risk or for speculating on the future price of an asset. They are also used for arbitrage – the practice of taking advantage of a price difference between two or more markets.
What are the risks associated with trading Exchange Traded Derivatives?
As with all financial instruments, trading in Exchange Traded Derivatives can have risks. Market risk (the risk that the value of the derivative will decrease due to a change in value of the underlying asset), liquidity risk and counterparty risk are potential risks. However, unlike OTC derivatives, Exchange Traded Derivatives have minimal counterparty risk due to the role of the exchange as an intermediary.
What is the role of the exchange in Exchange Traded Derivatives?
The exchange acts as an intermediary and takes on the risk if a party defaults on their contract. This reduces the overall counterparty risk. The exchange also provides a transparent and regulated platform to trade these financial instruments.
Are Exchange Traded Derivatives suitable for all types of investors?
All investments have inherent risk and it is important to understand the specific product, its market, and its risks before investing. Given the complexity and potential for rapid loss, Exchange Traded Derivatives are more suitable for sophisticated and professional investors.
Related Finance Terms
- Options Contract
- Futures Contract
- Commodities Exchange
- Derivative Instrument
- Hedging
Sources for More Information
