What Is an Exchange Traded Derivative?
An exchange traded derivative is a financial instrument that trades on a regulated exchange and whose value is based on the value of another asset. Simply put, these are derivatives that are traded in a regulated fashion. Exchange traded derivatives have become increasingly popular because of the advantages they have over over-the-counter (OTC) derivatives, such as standardization, liquidity, and elimination of default risk. Futures and options are two of the most popular exchange traded derivatives. These derivatives can be used to hedge exposure or speculate on a wide range of financial assets like commodities, equities, currencies, and even interest rates.
Exchange Traded Derivative Explained
Exchange traded derivatives are well suited for the retail investor, unlike their over-the-counter cousins. In the OTC market, it is easy to get lost in the complexity of the instrument and the exact nature of what is being traded. In that regard, exchange traded derivatives have two big advantages:
- Standardization: The exchange has standardized terms and specifications for each derivative contract, making it easy for the investor to determine how many contracts can be bought or sold. Each individual contract is also of a size that is not daunting for the small investor.
- Elimination of default risk: The derivatives exchange itself acts as the counterparty for each transaction involving an exchange traded derivative, effectively becoming the seller for every buyer, and the buyer for every seller. This eliminates the risk that the counterparty to the derivative transaction may default on its obligations
Another defining characteristic of exchange traded derivatives is their mark-to-market feature, wherein gains and losses on every derivative contract are calculated on a daily basis. If the client has incurred losses that have eroded the margin put up, he or she will have to replenish the required capital in a timely manner or risk the derivative position being sold off by the firm.
Exchange Traded Derivatives and Institutional Investors
Exchange traded derivatives are not favored by large institutions because of the very features that make them appealing to small investors. For instance, standardized contracts may not be useful to institutions that generally trade large amounts of derivatives because of the smaller notional value of exchange traded derivatives and their lack of customization. Exchange traded derivatives are also totally transparent, which may be a hindrance to large institutions who generally do not want their trading intentions known to the public or their competitors. Institutional investors tend to work directly with issuers and investment banks to create tailored investments that give them the exact risk and reward profile they are looking for.