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History of Accounting
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Margin Mechanism in Exchange Traded Derivatives
When it comes to exchange traded derivatives, one of the first things that need to be understood is the margin mechanism. Since most people that use exchange traded derivatives also use leverage, this is the procedure that they have to follow. The process may seem to be complicated. However, it is one of the wonders […]
Applications of Equity Valuation
“Valuation” or the process of assigning a fixed numerical value to the present and potential of a business is considered by many experts to be the most important part of corporate finance and financial markets. The most coveted and highly paid jobs in the financial markets are in this domain. The reason for this is […]
The Future of Financial Modelling
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In the previous article, we studied about exchange traded derivatives. We studied their defining features and found out the reason behind their popularity. However, exchange traded derivatives are of many types. They are traded all over the world in different stock exchanges. Hence, there are many different types of exchange traded derivatives. In this article, we will have a closer look at some of the more prominent types of derivatives.
The foremost asset class used in exchange traded derivatives is common stock. These types of derivatives are called stock related derivatives. Stock derivatives are available in a few types meaning that there can be stock forwards and stock options. Usually stock swaps are not traded over any exchange even though they may become part of over the counter transactions. Stock forwards and options enable people to make highly leveraged bets on the price movement in a particular stock if they are confident that the given stock will surely rise or fall in value. Worldwide stock derivatives are considered to be leading indicators predicting the direction of the future movement of stock.
Just like there are stock derivatives, there are also index related derivatives. This means that instead of buying or selling futures and options in a given stock, the investors can buy or sell the entire exchange. Since the exchange is nothing but a portfolio of stocks, these can also be considered to be a class of stock related derivatives.
However, there is one important difference. Stock options can be settled in cash or in kind meaning that somebody can demand actual delivery of the stocks. Index derivatives however cannot be settled in kind. Since there is no such thing as one unit of S&P 500, physical delivery is impossible.
Some of the commonly traded index related derivatives include the S&P 500, Nikkei, Nasdaq, Nifty 50 etc.
Derivatives contracts pertaining to currencies are also commonly listed on many exchanges for trading. Thus investors can go long or short on these currency pairs. The over the counter market provides a wide range of contracts that can negotiated as and when needed. Contrary to this, the exchange traded derivatives market only provides a few popular currency pairs that are listed. Since the contracts are standardized and liquidity is a concern, the index offers standardized contracts on for a few pairs of currencies which are highly traded.
For instance, the National Stock Exchange in India offers exchange traded derivatives on only four pairs of currencies which are:
Futures contracts are available for these four pairs. However, options are available for only one pair viz. Indian Rupee to US Dollar.
In most countries, commodities are the widely used for derivative trading. Even the first derivative exchange i.e. the Chicago Board of Trade was created to facilitate derivative trading in commodities. In most countries there are multiple exchanges that offer trading opportunities in thousands of commodities. Hence, there are thousands of contracts available in these markets. This is what makes it difficult to trade these markets. Commodities markets were earlier used by people to hedge their risks. However, in the recent past it has become highly speculative.
Real estate derivatives were at the heart of the recent economic meltdown in 2008. Derivatives have not left the world of real estate untouched. Instead, it was common practice to break down the cash flow from real estate rentals into bond payments. This is what securitization of assets was all about. These assets were listed on some of the premier exchanges in the US and were amongst the widely traded.
Recently, Eurex has also listed a new kind of derivative called Property Index Futures. Real estate exchange traded derivatives are highly structured and complex instruments and require special skills and knowledge from investors.
Therefore, exchange traded derivatives are available in a wide variety of underlying assets. This has made it possible for the average retail investor to trade them. The scope of exchange traded derivatives is expanding even further every year. Although, their association with economic meltdown has reduced the popularity, many investors still consider them to be good avenues for investments
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