Derivatives market

Last updated July 26, 2024

The derivatives market is the financial market for derivatives - financial instruments like futures contracts or options - which are derived from other forms of assets.

The market can be divided into two, that for exchange-traded derivatives and that for over-the-counter derivatives. The legal nature of these products is very different, as well as the way they are traded, though many market participants are active in both. The derivatives market in Europe has a notional amount of €660 trillion.^[1]

Participants in a derivative market

Participants in a derivative market can be segregated into four sets based on their trading motives.^[2]

Futures markets

Futures exchanges, such as Euronext.liffe and the Chicago Mercantile Exchange, trade in standardized derivative contracts. These are options contracts, swaps contracts and futures contracts on a whole range of underlying products. The members of the exchange hold positions in these contracts with the exchange, who acts as central counterparty. When one party goes long (buys a futures contract), another goes short (sells). When a new contract is introduced, the total position in the contract is zero. Therefore, the sum of all the long positions must be equal to the sum of all the short positions. In other words, risk is transferred from one party to another is a type of a zero sum game. The total notional amount of all the outstanding positions at the end of June 2004 stood at $53 trillion (source: Bank for International Settlements (BIS): ). That figure grew to $81 trillion by the end of March 2008 (source: BIS )

Over-the-counter markets

Tailor-made derivatives, not traded on a futures exchange are traded on over-the-counter markets, also known as the OTC market. These consist of investment banks with traders who make markets in these derivatives, and clients such as hedge funds, commercial banks, government-sponsored enterprises, etc. Products that are always traded over-the-counter are swaps, forward rate agreements, forward contracts, credit derivatives, accumulators etc. The total notional amount of all the outstanding positions at the end of June 2004 stood at $220 trillion (source: BIS: ). By the end of 2007 this figure had risen to $596 trillion and in 2009 it stood at $615 trillion (source: BIS: )

OTC Markets are generally separated into two key segments: the customer market and the interdealer market. Customers almost exclusively trade through dealers because of the high search and transaction costs. Dealers are large institutions that arrange transactions for their customers, utilizing their specialized knowledge, expertise, and access to capital. In order to hedge the risks incurred by transacting with customers, dealers turn to the interdealer market, or the exchange-traded markets. Dealers can also trade for themselves or act as market makers in the OTC market (source: Federal Reserve Bank of Chicago ).

Netting

US: Figures below are from the second quarter of 2008 Archived 2007-12-26 at the Wayback Machine

Total derivatives (notional amount): $182.2 trillion (second quarter, 2008)
- Interest rate contracts: $145.0 trillion (86%)
- Foreign exchange contracts: $18.2 trillion(10%)
- 2008 Second Quarter, banks reported trading revenues of $1.6 billion
Total number of commercial banks holding derivatives: 975

Positions in the OTC derivatives market have increased at a rapid pace since the last triennial survey was undertaken in 2004. Notional amounts outstanding of such instruments totalled $516 trillion at the end of June 2007 (according to the Bank for International Settlements ), 135% higher than the level recorded in the 2004 survey (Graph 4). This corresponds to an annualised compound rate of growth of 34%, which is higher than the approximatively 25% average annual rate of increase since positions in OTC derivatives were first surveyed by the BIS in 1995. Notional amounts outstanding provide useful information on the structure of the OTC derivatives market but should not be interpreted as a measure of the riskiness of these positions. Gross market values, which represent the cost of replacing all open contracts at the prevailing market prices, have increased by 74% since 2004, to $11 trillion at the end of June 2007. (page 28)

Notional amounts outstanding as of December 2012 are $632 trillion as per recent survey.[3]

Role in the financial crisis of 2007–2008

The derivative markets played an important role in the financial crisis of 2007–2008. Credit default swaps (CDSs), financial instruments traded on the over the counter derivatives markets, and mortgage-backed securities (MBSs), a type of securitized debt were notable contributors.^[4]^[5] The leveraged operations are said to have generated an "irrational appeal" for risk taking, and the lack of clearing obligations also appeared as very damaging for the balance of the market. More specifically, interdealer collateral management and risk management systems proved to be inadequate. The G-20's proposals for financial markets reform all stress these points, and suggest:

higher capital standards
stronger risk management
international surveillance of financial firms' operations
dynamic capital rules.

Related Research Articles

In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the underlying. Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation, or getting access to otherwise hard-to-trade assets or markets.

A commodity market is a market that trades in the primary economic sector rather than manufactured products, such as cocoa, fruit and sugar. Hard commodities are mined, such as gold and oil. Futures contracts are the oldest way of investing in commodities. Commodity markets can include physical trading and derivatives trading using spot prices, forwards, futures, and options on futures. Farmers have used a simple form of derivative trading in the commodity market for centuries for price risk management.

In finance, an interest rate swap (IRS) is an interest rate derivative (IRD). It involves exchange of interest rates between two parties. In particular it is a "linear" IRD and one of the most liquid, benchmark products. It has associations with forward rate agreements (FRAs), and with zero coupon swaps (ZCSs).

In finance, a credit derivative refers to any one of "various instruments and techniques designed to separate and then transfer the credit risk" or the risk of an event of default of a corporate or sovereign borrower, transferring it to an entity other than the lender or debtholder.

<span class="mw-page-title-main">Credit default swap</span> Financial swap agreement in case of default

A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default or other credit event. That is, the seller of the CDS insures the buyer against some reference asset defaulting. The buyer of the CDS makes a series of payments to the seller and, in exchange, may expect to receive a payoff if the asset defaults.

The International Swaps and Derivatives Association is a trade organization of participants in the market for over-the-counter derivatives.

In finance, a swap is an agreement between two counterparties to exchange financial instruments, cashflows, or payments for a certain time. The instruments can be almost anything but most swaps involve cash based on a notional principal amount.

In finance, an interest rate derivative (IRD) is a derivative whose payments are determined through calculation techniques where the underlying benchmark product is an interest rate, or set of different interest rates. There are a multitude of different interest rate indices that can be used in this definition.

The foreign exchange market is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all aspects of buying, selling and exchanging currencies at current or determined prices. In terms of trading volume, it is by far the largest market in the world, followed by the credit market.

Over-the-counter (OTC) or off-exchange trading or pink sheet trading is done directly between two parties, without the supervision of an exchange. It is contrasted with exchange trading, which occurs via exchanges. A stock exchange has the benefit of facilitating liquidity, providing transparency, and maintaining the current market price. In an OTC trade, the price is not necessarily publicly disclosed.

Security market is a component of the wider financial market where securities can be bought and sold between subjects of the economy, on the basis of demand and supply. Security markets encompasses stock markets, bond markets and derivatives markets where prices can be determined and participants both professional and non professional can meet.

In finance, a currency swap is an interest rate derivative (IRD). In particular it is a linear IRD, and one of the most liquid benchmark products spanning multiple currencies simultaneously. It has pricing associations with interest rate swaps (IRSs), foreign exchange (FX) rates, and FX swaps (FXSs).

Foreign exchange risk is a financial risk that exists when a financial transaction is denominated in a currency other than the domestic currency of the company. The exchange risk arises when there is a risk of an unfavourable change in exchange rate between the domestic currency and the denominated currency before the date when the transaction is completed.

Basis risk in finance is the risk associated with imperfect hedging due to the variables or characteristics that affect the difference between the futures contract and the underlying "cash" position. It arises because of the difference between the price of the asset to be hedged and the price of the asset serving as the hedge before expiration, namely b = S - F. Barring idiosyncratic influence by the other aspects to be enumerated just below, by the time of expiration this simple difference will be eliminated by arbitrage. The other aspects that give rise to basis risk include

In finance, a stock market index future is a cash-settled futures contract on the value of a particular stock market index. The turnover for the global market in exchange-traded equity index futures is notionally valued, for 2008, by the Bank for International Settlements at US$130 trillion.

A central clearing counterparty (CCP), also referred to as a central counterparty, is a financial market infrastructure organization that takes on counterparty credit risk between parties to a transaction and provides clearing and settlement services for trades in foreign exchange, securities, options, and derivative contracts. CCPs are highly regulated institutions that specialize in managing counterparty credit risk.

TP ICAP Group plc is a financial services firm headquartered in London, United Kingdom. Its stock is listed on the London Stock Exchange and is a constituent of the FTSE 250 Index.

LCH is a financial market infrastructure company headquartered in London that provides clearing services to major international exchanges and to a range of OTC markets. The LCH Group includes two main entities: LCH Limited based in London and LCH SA based in Paris.

Söhnke Matthias Bartram is a professor in the Department of Finance at Warwick Business School (WBS). He is also a research fellow in the Financial Economics programme and the International Macroeconomics and Finance programme of the Centre for Economic Policy Research (CEPR), a charter member of Risk Who's Who, and a member of an international think tank for policy advice to the German government. Prior to joining the University of Warwick, he held faculty positions at Lancaster University and Maastricht University and worked for several years in quantitative investment management at State Street Global Advisors as Head of the London Advanced Research Center.

In finance, a dividend future is an exchange-traded derivative contract that allows investors to take positions on future dividend payments. Dividend futures can be on a single company, a basket of companies, or on an Equity index. They settle on the amount of dividend paid by the company, the basket of companies, or the index during the period of the contract.

References

↑ "ESMA data analysis values EU derivatives market at €660 trillion with central clearing increasing significantly". esma.europa.eu. Retrieved 2018-10-19.
↑ Sasidharan (1 December 2009). Options Trading Strategies For The Bear Mkts. Tata McGraw-Hill Education. p. 4. ISBN 978-0-07-015272-4.
↑ http://www.bis.org/statistics/dt1920a.pdf ^{[ bare URL PDF ]}
↑ Adam Tooze, Crashed: How a Decade of Financial Crises Changed the World, London: Allen Lane and New York: Viking, 2018. ISBN 9781846140365
↑ Financial Crisis Inquiry Commission Hearing (2010). The Role of Derivatives in the Financial Crisis – Testimony of Michael Greenberger, Law School Professor, University of Maryland School of Law (PDF).

External links

Understanding Derivatives: Markets and Infrastructure – Federal Reserve Bank of Chicago
PBS (WGBH, Boston), "The Warning", Frontline TV public affairs program, October 20, 2009. "At the center of it all he finds Brooksley Born, who speaks for the first time on television about her failed campaign to regulate the secretive, multitrillion-dollar derivatives market whose crash helped trigger the financial collapse in the fall of 2008."

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[1] "ESMA data analysis values EU derivatives market at €660 trillion with central clearing increasing significantly". esma.europa.eu. Retrieved 2018-10-19.

[Sasidharan2009-2] Sasidharan (1 December 2009). Options Trading Strategies For The Bear Mkts. Tata McGraw-Hill Education. p. 4. ISBN 978-0-07-015272-4.

[3] ttp://www.bis.org/statistics/dt1920a.pdf ^{[ bare URL PDF ]}

[4] Adam Tooze, Crashed: How a Decade of Financial Crises Changed the World, London: Allen Lane and New York: Viking, 2018. ISBN 9781846140365

[5] Financial Crisis Inquiry Commission Hearing (2010). The Role of Derivatives in the Financial Crisis – Testimony of Michael Greenberger, Law School Professor, University of Maryland School of Law (PDF).

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