Exchange-traded derivatives (ETDs) represent a dynamic category of financial instruments that are traded on organised exchanges. These derivatives derive their value from an underlying asset and are standardised, making them easily tradable. This introduction explores the various types of ETDs and provides illustrative examples to enhance understanding of their role in financial markets.
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What are Exchange-Traded Derivatives?
Exchange-traded derivatives are those derivative contracts that are traded on regulated and recognised exchanges. In India, the exchange-traded derivatives comprise futures and options contracts traded on exchanges like NSE (National Stock Exchange), BSE (Bombay Stock Exchange), and MCX (Multi Commodity Exchange). SEBI, or the Securities and Exchange Board of India, determines the rules for trading exchange-traded contracts in India.
Features and Benefits of Exchange-Traded Derivatives
Standardisation
Standardisation is one of the main features that distinguishes exchange-traded derivative contracts from other derivatives. When we say the contract is standardised, we mean it has predetermined terms and conditions, like expiry dates, lot size, settlement process, and underlying assets, making it easy for investors to find information regarding the same. For example, if you consider the Nifty Jan Futures contracts, all these contracts expire on the last Thursday of the month, have a lot size of 50 units, and are settled in cash.
Elimination of Counterparty Risk
Another important feature of derivatives traded on the exchange is that the exchange acts as the counterparty. In simple words, this simply means you are transacting with the exchange. So, the exchange is the seller if you are the buyer, and it is the buyer if you are the seller. Therefore, in the case of exchange-traded derivatives, there is no counterparty or default risk. So, you don’t have to worry about the opposite party defaulting, as it is the exchange itself.
High Liquidity
Since exchange-traded derivatives are standardised contracts traded on recognised exchanges, it makes it easier for traders to find each other. For example, in the case of stock options, such contracts are either traded on the NSE or BSE in India. So, all traders interested in trading stock options are either trading them on the NSE or BSE. Hence, exchange-traded contracts are highly liquid, so traders can buy, sell, or offset their positions easily.
Exchange Regulated
Lastly, exchange-traded contracts are regulated by the exchange. The exchange being an unbiased body, keeps this space safer for smaller investors. The exchange also publishes daily reports of all the major trades of the day. Doing that prevents big parties from exploiting smaller investors.
Disadvantage of Exchange-Traded Derivatives
Despite the benefits mentioned above, there is a strong case against exchange-traded contracts. The major advantage of these contracts—standardisation—also gives rise to its major disadvantage—loss of flexibility. Exchange-traded contracts are not tailored or negotiated as per the parties’ wishes.
Types of Exchange-Traded Derivatives
Futures and options contracts make up the exchange-traded derivatives market in India. However, you can trade the F&O contrast in multiple asset classes. So, in India, there are stock derivatives, index derivatives, commodity derivatives, and currency derivatives.
Stock Derivatives
Stock derivatives consist of derivative contracts of the stock futures and options contracts traded on the NSE and BSE. For example, HDFC Bank futures and options, TCS futures and options, etc.
Index Derivatives
Index derivative contracts are the most commonly traded derivative contracts on the stock exchanges in India. In an index derivative, the index is the underlying asset. In India, index derivatives include futures and options contracts of the Nifty and Nifty Bank.
Commodity Derivatives
Here, commodities like gold, copper, crude oil, or agricultural produce like coffee or wheat are the underlying assets. On the MCX you can trade futures and options on such commodities.
Currency Derivatives
In these types of derivatives, the underlying asset is a currency, like the US Dollar, British Pound, Euro, etc. Exchange-traded currency derivatives are regulated compared to the ones traded over the counter. You can trade currencies on the exchanges like the NSE and BSE.
Conclusion
Exchange-traded derivatives encompass a diverse array of standardised financial instruments traded on organised exchanges. From futures and options to other derivative products, ETDs play a crucial role in providing investors with avenues for risk management, speculation, and portfolio diversification. The examples presented underscore the versatility of ETDs and their significance in the ever-evolving landscape of financial markets. As investors navigate these standardised instruments, a comprehensive understanding of the types and examples of ETDs becomes essential for informed decision-making and effective participation in the dynamic world of exchange-traded derivatives.
