DERIVATIVE MARKET

Introduction

The Derivative Market is the financial market for the derivatives. It is the market where exchange of derivatives takes place. Derivatives are defined as one type of securities whose price is derived from the underlying assets. The underlying assets are stocks, bonds, currencies, market indices etc. Derivatives can also be referred as the contract between two parties. The derivatives can be classified as Future contracts, Forward contracts, Swaps, Option and Credit derivatives.

Types of Derivative Market

The Derivative Market can be classified into 2 types:
i) Exchange Traded Derivative Market
ii) Over the Counter Derivative Market

Exchange Traded Derivatives Markets are the markets where the derivatives are traded through specialized derivative. Over the Counter Derivative Markets are the markets where the derivatives are privately traded between the two parties.

In the Exchange Traded Derivative Market, exchange acts as the main party and intermediary to all related transactions and takes initial margin from both sides of the trade to act as a guarantee. In the process of trading of derivatives actually risk is traded between the two parties. Some types of derivative instruments may trade n traditional exchanges. Hybrid instruments like convertible bonds may be listed on stock or bond exchanges. Warrants may be listed on equity exchanges. Performance Rights and various other instruments are listed on equity exchanges. These publicly traded derivatives provide investors access to risk as well as rewards.Some of the derivative exchanges are Korea Exchange, Eurex, CME Group New York Mercantile Exchange etc. The process of investing in a derivative market works by establishing a situation where one party sells one futures contract while the counterparty purchases a new futures contract. The result of the two transactions effectively produces a position that is considered to be at zero. This approach essentially transfers the bulk of the risk to the counterparty in the arrangement and makes it possible to earn a return by exchanging a long position for a short one.











In Over the Counter (OTC) Derivatives are the contracts which are traded directly between the two parties, without going through an exchange or intermediary. Products like swaps, forward rate agreements etc are traded in this way. It is the largest market for derivatives. Reporting of OTC amounts are difficult because trades occur privately without any exchange. Since OTC derivatives are traded privately without any exchange they are subjected to counterparty risk. The main participants of OTC market are the Investment Banks, Commercial Banks, Government Sponsored Enterprises and Hedge Funds. The investment banks markets the derivatives through traders to the clients like hedge funds and the rest.

Derivative market and Financial Risk

Derivatives play a vital role in managing the risks of both financial and non-financial institutions. In the present world, it has become a rising concern that derivative market operations may destabilize the efficiency of financial markets. In today’s world the companies are using forward contracts, future contracts, options, swaps and other various combinations of derivatives to manage risk and to increase returns in the financial and non-financial firms. The growth of derivatives market has revealed the increasing market demand for risk managing instruments in the economy. But, the major concern is that, the main components of Over the Counter (OTC) derivatives are interest rates and currency swaps. So, the economy will suffer surely if the derivative instruments are misused and if a major fault takes place in derivatives market.