Exchange Traded Derivative

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

1. 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.
2. Standardization: ETDs are standardized contracts with transparent pricing, which can be appealing to investors. Standardization also elicits more efficient processing within financial systems.
3. 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)

Related Finance Terms

• Options Contract
• Futures Contract
• Commodities Exchange
• Derivative Instrument
• Hedging

Sources for More Information

• Investopedia
• The Balance
• Corporate Finance Institute
• The Economist