In the financial world, derivatives are important as they keep transaction costs low in the market; they are defined as financial contracts that have a value that is correlated with an underlying asset. With their complexity, these financial instruments are used in many ways, which include accessing additional markets or assets as well as hedging. Some Derivatives are traded (OTC) over the counter while other specific contracts are traded via selected exchanges. This is what this article is going to expand on today; exchange traded derivatives.
What is an Exchange Traded Derivative?
An exchange traded derivative is a type of derivative traded on a regulated exchange. This type of derivative increasingly continues to be the preference over (OTC) over the counter derivatives as they have more advantages. These advantages include liquidity, standardization, eradication of default risk, and so on (to be expanded below).
One interesting feature of exchange traded derivatives is the daily calculation of losses and gains on each and every derivative contract, which is called mark-to-market. In this case, if a client experiences a loss that ultimately erodes the underlying margin, then they would be required to replace the necessary capital, or else the firm may sell off their derivative position.
Two of the most popular exchange traded derivatives are options and futures as they can assist in hedging exposure as well as speculate on a variety of financial assets like currencies, equities, interest rates, commodities, and so on. Exchange Traded Derivatives are more suitable for retail investors, and in many ways, this gives it an advantage over over-the-counter derivatives. Let’s look at some advantages of Exchange Traded Derivatives.
The two main advantages of Exchange Traded Derivatives
Default risk Eliminated
The specific derivatives exchange behaves as counterparty in every exchange traded derivatives transaction, which essentially makes it every buyer’s seller and every seller’s buyer. Thus it can eliminate any risks of defaulting and dishonest participants.
An advantage that Exchange Traded Derivatives have is that the particular exchange will have specifications and terms dedicated to each derivative contract. This way, investors will find it a lot easier to determine the number of the contract to be purchased or sold. Moreover, smaller investors are catered for as the sizes of each individual contract are quite reasonable.
The differences between Exchange Traded Derivatives and (OTC) derivatives
- There is a lot more Transparency in Exchange Traded derivatives as compared to over-the-counter.
- OTC trading is done 24/7, whereas with exchange traded Derivatives trading is only done during standard trading hours.
- One huge difference between these two is that with Exchange traded Derivatives is that the exchange is physically present, however on the other hand, with OTC, everything is digitalized.
- Exchange traded Derivation usually deals with larger businesses, while OTC is used by smaller businesses.
- OTC contracts are made on request, customized with specific requirements, whereas, and exchange only deals with standardized quality and quantity products.
- With an over the counter market, the dealers are the market makers, and their job is to quote the buying and selling price of the financial instruments as transacted between the participants. Whereas, with an exchange, the exchange itself is the market maker, because the prices are dependent on supply and demand.
- With an exchange, if there is an imbalance in supply and demand, there are measures to avoid acute price highs or lows, which involve the exchange stopping the trading of a particular stock from allowing balance to be restored whereas OTC does not have any mechanism to prevent such occurrences.
At the end of the day, Derivatives are generally valuable in the financial world, whether it be OTC or on an exchange. In this case, looking at what we have covered above, Exchange Traded Derivatives are evidently a step ahead of OTC due to the several advantages that are present. These advantages include flexibility to alter the investment portfolio whenever you need to; it is very transparent and provides all the necessary information needed; fair prices are preserved, thereby reducing risk and exchange offers more liquidity to encash financial instruments as it becomes necessary. All these factors contribute to the leg-up that Exchange traded Derivatives have over (OTC).
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