Role of Investment Bankers in Derivatives Market
The derivatives department is a highly specialized department in the modern-day investment bank. This is because, in terms of size, the derivatives department easily dwarfs all other departments in the investment bank. For instance, the worldwide market for derivative contracts is said to be valued at $79 trillion! This is definitely a notional value since […]
Types of Covenants
In the previous article, we had a closer look at the concept of covenants as well as indentures. However, we only covered the basics. Indentures and covenants are extremely important to the investors who deploy their money in fixed-income securities. It is for this reason that investors need to have a better understanding of the […]
Investment Banking Issues: Why Do IPOs Get Underpriced?
Every year investment bankers help several companies raise capital from the markets. They help these companies in issuing securities and accessing more funds. The issue is that when these companies access the capital markets, they are often growing at a phenomenal pace. This means that these firms have a lot of projects where they want […]
Compounding Intervals and Interest Rate
Theoretically there are two types of interest rates, simple and compounding. However, in finance the word interest usually refers to compound interest. Simple interest almost never factors in financial calculations. In all calculations related to present values and future values, compound interest is used. However, as a student of corporate finance, it is essential to […]
Multiproduct Contribution Margin
Finding the Contribution Margin: It begins with the same old way. Companies have to compute the contribution margin for each of their products. This is a possibility if a company has a couple of hundred products. If there are thousands of products, we may have to use the sales based approach mentioned in the end […]
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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