Understanding Financial Derivatives

Understanding Financial Derivatives

As per the official data released by nations’ central bank RBA, the total value of financial derivatives in Australia is around $37 trillion as on 31 June 2018. Derivatives are financial instruments involving a contract between two or more parties with a value dependent on an underlying stock such as commodity, stock, bond, currency, interest rates and market indexes. Financial institutions extensively use these financial tools and non-financial corporations for price and interest rate risk mitigation, undertake hedging and speculative positions. These contracts are used by market participants to hedge interest rates, inflation, equity, foreign exchange, price risk, and commodities.

The exposure to derivatives can be in the form of Exchange Traded Derivatives or Over the Counter (OTC) derivatives. OTCs are privately agreed and negotiated between two counterparties. On the other hand, Exchange Traded Derivatives are standardized and market-regulated instruments.

Derivatives offer significant advantages of improving price discovery, risk transfer and management, improving market efficiency and reducing market transaction costs. Before investing in derivatives, it is imperative for investors to understand the associated counterparty risks, price risks, liquidity risks, legal risks, and operational risks.

Futures are exchange-traded derivatives contracts involving purchase/sale of an underlying asset at a pre-defined price on a specified date in future. These can be index futures, interest rate futures, agricultural futures or even energy futures trading on Australian exchanges. For futures contracts, there are two types of market participants – hedgers and speculators — hedgers, target at stabilizing business revenues by taking possession of the underlying assets. However, speculators place bets on the future prices of assets.

Forwards are like futures as they are characterized by a future obligation to buy/sell an underlying asset at an agreed upon price. However, unlike futures, these are non-regulated, standardized contracts between two parties. Unlike futures, forwards are settled on maturity only. As often observed, Hedgers are involved in forwards exposure to eliminate asset price volatility while speculators, on the other hand, take futures exposure betting on the direction of asset price movement.

Options are also exchange-traded, regulated derivatives like Futures. However, the significant difference is the right and no obligation to buy/sell an asset at an agreed upon price in the future. Market participants can take positions in call options (right to purchase asset) or put options (right to sell an asset).

Swaps are derivatives contracts between two parties to exchange cash flows in future. Market participants can take exposure in commodity swaps, credit default swaps, equity swaps or even interest rate swaps. For example, a set of floating interest rate payments may be swapped for a fixed interest rate cash flows to avoid the interest rates fluctuation risk.

In Australia, derivative contracts trade over the ASX 50, ASX 200 and ASX property. Australia is the leading Asia-Pacific nation with one of the largest derivatives markets. Exchange trading of derivatives dates to 1960 at Sydney Greasy Wool Futures Exchange (SGWFE). This became the Sydney Futures Exchange, before merging with the ASX in 2006.  The market for exchange-traded derivatives is regulated by the Australian Securities and Investments Commission (ASIC).


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