Exchange Traded Derivatives
Now since we have a basic idea regarding what derivatives really are and the function that they perform, it time to get into a little more detail.
At this point, it is essential to introduce the concept of exchange traded derivatives and over the counter derivatives. We have briefly brushed on them in the previous few articles.
However, now we will understand them in more detail. The idea is to grasp why this bifurcation amongst the type of derivatives matters and how one can make best use of both types of derivatives.
The defining feature of the exchange traded derivatives is that they are standardized contracts. Lets use an example to explain this. Lets say we want to fix the price of 1260 kgs. of wheat that we expect to produce in the harvest season. We want to find a buyer in the derivatives market. Now the issues that we will face are:
- It might be difficult to find a buyer that wants a delivery on the exact same date that you plan to deliver. There may be a few days here and there in the delivery process
- It might be difficult to get a buyer in the exact geographical area that we are located in. Of course, buyers can and will be everywhere. However, locating them in a matter of seconds will be difficult
- It might be difficult to find a buyer that agrees on the exact terms of the contract that you want to draw out. It is likely that the buyer may feel that the contract is biased towards you.
- It might be difficult to get a buyer that might want the exact amount i.e. 1960 kgs of wheat. Instead, some buyer may want 450 kgs whereas others may want 2000 kgs.
The point, therefore is , that making buyers and sellers meet when they have extremely specific needs is a difficult job and cannot be done on an exchange.
In contrast, exchange traded derivatives are standardized contracts. Each contract will have a fixed expiration data, each contract will be for the same amount of quantity i.e. 100 kgs (assume). Hence, all the above mentioned difficulties become redundant.
The biggest and differentiating factor of exchange traded derivatives is that they are standardized contracts.
Easy To Offset
Since, exchange traded derivatives can be brought off the market at any given point of time, they provide the users with a lot of opportunity to offset their previous contract as and when required.
Consider the case of a farmer who has agreed to sell wheat to a merchant at a later data at a price fixed today. Later on, the farmer believes that he can get a better price in the market and wants to reverse the contract, what shall he do? In case of a customized contract, the farmer will have to negotiate with the other party and hope that they agree to reverse the contract. This puts the farmer at a competitive disadvantage if they change their mind.
This is not the case with exchange traded derivatives. Exchange traded derivatives can be offset in two ways:
- By selling the current position out in the market
- By buying an offsetting position at the updated price
Since both of these actions can easily be performed in a matter of seconds and without any negotiations, exchange traded derivatives are much more user friendly than their counterparts.
The exchange traded derivatives provide another major advantage. In case of exchange traded derivatives, neither party is directly facing a counterparty risk. This is because neither party is actually directly dealing with the other party.
Lets say, A enters into a contract with the exchange wherein exchange goes short and A goes long. The exchange will simultaneously enter into another contract with B wherein the exchange takes an offsetting position i.e. goes long.
Hence, both parties are contractually bound to the exchange. Since the exchange is a credible counterparty, the chances of default are greatly reduced making exchange traded derivatives a safer bet when it comes to credit risk.
Most traders around the world take it as a given that the exchange will never default on its liabilities. The day the exchange defaults, it will be out of business.
The exchange is a neutral body. Also, exchanges are subject to a lot of regulation. It is for these reasons that exchange traded derivatives are a safer bet. When one trades in exchange traded derivatives, it is unlikely that they will come across a scenario wherein a few participants have cornered the market i.e. have complete control over the commodity in the market.
Events like short squeezes do happen but they are not as easy to execute while trading exchange traded derivatives because the exchange has to publish information about all the major trades executed on a given day. This prevents the big parties from cornering the markets.
Lastly, exchange traded derivatives have a lot of market depth. This means that these markets are highly liquid. Hence, if any person holding exchange traded derivatives wants to reverse their position, they will easily find a counterparty to sell their stake to or make an opposite bet against.
Since the markets are so liquid, these parties can be found at the click of a button and the stake can be sold without any major loss in value.
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- What are Derivatives ?
- The Need for Derivatives
- History of Derivatives
- The 4 Basic Types of Derivatives
- Risks Involved in Derivative Contracts
- Commonly Used Terms in Derivative Market
- Exchange Traded Derivatives
- Margin Mechanism in Exchange Traded Derivatives
- Examples of Exchange Traded Derivatives
- Securitization: The Making of an Exchange Traded Derivative
- Notional Value: Derivatives Markets
- Over the Counter Derivatives Regulation
- Financial and Economic Models used in the Equity and Currency Markets
- An Introduction to Hedge Funds
- How Hedge Funds Makes Money ?
- Types of Hedge Funds
- Why Hedge Funds Fail ?
- Hedge Funds vs. Mutual Funds
- Hedge Funds and Money Laundering
- Hedge Funds and Regulations
- Hedge Funds and Conflict Of Interest
- Hedge Funds and Leverage
- Structuring a Hedge Fund Business
- Vulture Funds: The Name Says It All
- What is Prime Brokerage ?
- What is Algorithmic Trading ?
- Extrapolation: The Root Cause behind the Bubbles
- Are Debt Funds Better Than Bank Deposits?
- Why Do Mutual Funds Lend To Promoters?