Derivative Instruments and Features

A derivative is a financial instrument whose value is derived from the value of another underlying instrument or asset. This underlying can be a stock, a bond, a currency, a commodity, or even an abstract concept like an interest rate or market index.

Derivatives can be broadly categorized into two main types based on the nature of the obligation they create for the parties involved.

1. Firm Commitments

A firm commitment is an agreement where two parties agree to transact a specific amount of an asset at a predetermined price and date in the future. Both parties are obligated to fulfill their side of the contract at settlement. Key examples include:

• Futures Contracts - Standardized agreements traded on exchanges
• Forward Contracts - Customized agreements traded over-the-counter
• Swaps - Series of exchanges over multiple periods

2. Contingent Claims

Contingent claims give one party the right, but not the obligation, to buy or sell the underlying asset under predetermined terms in the future. The other party has the obligation to perform if the first party chooses to exercise their right. The most common example is an option contract.

Derivatives can be based on a wide variety of underlying assets and rates. Here are the primary categories:

Equities

Equity derivatives derive their value from the price of stocks. The underlying can be:

• An individual stock or a specific group of stocks
• A stock market index, like the S&P 500

Fixed-Income Instruments and Interest Rates

These derivatives are linked to debt instruments and the cost of borrowing money.

• Derivatives on bonds include options, futures, forwards, and swaps based on the price of specific bonds
• Interest rate derivatives are based on an underlying interest rate. These are the most widely used derivatives in the financial markets

Currencies

Currency derivatives are used to manage foreign exchange (FX) risk. Their value is based on the exchange rate between two currencies.

Commodities

Commodity derivatives are used either to reduce commodity price risk for producers and consumers or to gain investment exposure to commodity prices. Underlyings include agricultural products, metals, and energy.

Credit

Credit derivatives are contracts based on the credit risk of an issuer or a group of issuers. They allow parties to transfer the risk that a borrower will default on its debt.

Other Underlyings

The derivatives market is highly innovative, with contracts being created on a vast range of other underlyings. Examples include derivatives based on weather conditions, cryptocurrencies, longevity (life expectancy), electricity prices, and the occurrence of natural disasters.

Derivatives are traded in two distinct types of markets: Over-the-Counter (OTC) and Exchange-Traded (ETD).

Over-the-Counter (OTC) Derivatives Markets

OTC markets are private markets where participants trade directly with one another.

• OTC markets are also known as dealer markets
• The dealers who facilitate these trades are called market makers
• Common OTC contracts include forward contracts, swaps, and OTC options
• These markets offer high levels of flexibility and privacy, as contract terms can be fully customized between the parties
• The trade-off for this customization is that OTC markets are more private and therefore less transparent than exchanges

Exchange-Traded Derivatives (ETD) Markets

ETD markets are centralized venues where derivatives are traded publicly.

• Contracts traded on an exchange are formal and standardized. This means the contract size, expiration date, and other terms are predefined by the exchange
• ETD markets are generally more liquid and transparent than OTC markets
• A key feature is the role of the clearinghouse, which guarantees contracts against the risk of default
• ETD contracts are subject to a daily settlement of gains and losses, a process known as marking-to-market

Comparison: OTC vs. ETD Markets

The following table summarizes the key differences between the two market structures:

Feature	Over-the-Counter (OTC)	Exchange-Traded (ETD)
Transparency	Lower	Higher
Liquidity	Lower	Higher
Customization / Flexibility	Higher	Lower
Trading / Transaction Costs	Higher	Lower
Privacy	Higher	Lower