DEFINITION OF EXCHANGE TRADED DERIVATIVES AND ITS ADVANTAGES

A financial instrument that trade on a regulated exchange and whose value is based on the value of another asset is called an exchange-traded derivative. Basically, there are derivatives that are traded in a regulated fashion. Because of the advantages that exchange-traded derivatives have over over-the-counter derivatives – standardization, liquidity, and elimination of default risk – it has become popular. The two most popular exchange-traded derivatives are futures and options. To hedge exposure or speculate on a wide range of financial assets like equities, commodities, currencies, and even interest rates these derivatives can be at used.

Unlike the over-the-counter market, exchange-traded derivatives are well-suited for the retail investor. It is easy to get lost in the complexity of the instrument and the exact nature of what is being traded in the over-the-counter market. Therefore, exchange-traded derivatives gave two big advantages:

Standardization – to make it easy for the investor to determine how many contracts can be bought or sold, the exchange has standardized terms and specifications for each derivative contract. The size of each individual contract is not daunting for the small investor.

Elimination of default risk – the derivatives exchange itself acts as the counterparty for each transaction involving an exchange-traded derivative, the buyer for every seller, and effectively becoming the seller for every buyer. So, the risk that the counterparty to the derivative transaction may default on its obligations can be eliminated.

Gains and losses on every derivative contract are calculated on a daily basis which is another one defining characteristics of exchange-traded derivatives through their mark-to-market feature. The client will have to replenish the required capital in a timely manner or risk the derivative position being sold off by the firm if he has incurred losses that have eroded the margin put up.

Because of the very features that make exchange-traded derivatives appealing to small investors, large institutions are not favored by it. For example, since the smaller notional value of exchange-traded derivatives and lack of customization, standardized contracts may not be useful to institutions that generally trade large amounts of derivatives. A hindrance to large institutions that generally do not want their trading intentions known to the public or their competitors is that exchange-traded derivatives are also totally transparent. To create tailored investments that give the institutional investors the exact risk and reward profile they are looking for, they tend to work directly with issuers and investment banks.

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