How are Financial Derivatives Traded?

In this video we will learn how financial Derivatives are Traded, what are the major derivative types and what is the economic function of the derivatives market?

Hi my name is patrick boyle welcome to my youtube channel this is the second video in a series on financial derivatives where i aim to take you from the solut beginner level through to expert level over the series of videos in today’s video we’re going to learn how derivatives are traded what are the major derivative types and what is the economic function of the

Derivatives market these classes are all based on my book trading and pricing financial derivatives if you want to follow along with the book and on amazon link is provided in the description below so first let’s learn how our derivatives traded there’s two groups of derivatives contracts and they’re distinguished by the way that they are traded in the market the

First group are over-the-counter derivatives and the second group are exchange-traded derivatives over-the-counter derivatives are contracts that are traded directly between two parties without going through an exchange products such as swaps forward rate agreements exotic options and many other derivatives are typically traded in this way the over-the-counter are

Otc derivatives market is the largest market for derivatives the otc market is largely made up of banks large corporations and other highly sophisticated parties because over-the-counter derivatives are not traded on an exchange there’s no central counterparty thus they are subject to counterparty risk the risk of one party defaulting a settlement or a closure of

The contract like any ordinary legal contract despite the complexity and risks of over-the-counter trading most transactions are quite standardized with standardized documentation there has been a large push in recent years from gov and financial regulators since the financial crisis of 2007 to 2008 to bring a sizable proportion of the otc markets on to clearing

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Platforms in order to improve overall financial stability and in a later video i’ll explain what a clearinghouse is in the derivatives market and why it might matter exchange-traded derivatives are adults that are traded via specialized derivatives exchange such as the cme group or your ex a derivatives exchange is a market for standardized contracts that have

Been defined by the exchange are traded a derivatives exchange acts as an intermediary to all related transactions and takes margin payments from the customers who trade with them to act as a guarantee some types of derivative instruments also may trade on traditional exchanges for instance hybrid instruments such as convertible bonds or convertible preferred stock

May be listed on stock or bond exchanges warrants are rights issues may be listed on equity exchanges most exchange-traded derivatives are traded electronically one of the earliest examples of widespread electronic trading was on globex thus eme groups electronic trading platform that allows access to a variety of financial foreign exchange and commodity markets

Most investors who wish to trade exchange-traded derivatives open an account with a derivatives broker or an investment bank and then trade with them using their brokers trading app or a third party trading out next let’s talk about the major derivative contract types the most common types of derivatives contracts are forwards forwards are an over-the-counter

Contract between two parties where payment takes place at a specific i’m in the future at today’s predetermined price futures which are an exchange listed contract to buy or sell an asset on or before future date at a price specified today a futures contract is very similar to a forward contract but differs from a forward contract in that the futures contract is

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A standardized contract which is then backed by a clearing house working with an exchange where the contract can be bought and sold the forward contract is an on standardized over-the-counter contract written by the parties themselves options options are a derivative financial instrument that specify a contract between two parties for a future transaction on an

Asset at a reference price which we call the strike price the buyer of the option gains the right but not the obligation to engage in that transaction well the seller incurs the corresponding obligation to fulfill the transaction options can be either exchange-traded or over-the-counter an option which conveys the right to buy something at a specific price is

Called a call option an option which conveys the right to sell something at a specific price is called a put option warrants warrants are similar to auctions are similar to a call option anyhow but it’s typically issued by a company on its own stock and so when it’s exercised new equity is issues causing ownership dilution to common stock holders note that with

All of these products i’m always referring to the derivatives as contracts and that’s because they are all legal contracts between two parties i’ll explain this in greater detail in a future video but you’ll probably notice when you hear traders speak that they might talk about being long or short hundred contracts for example our derivatives are not ownership

Of the underlying stock bond our index they’re simply contracts with payoffs that reference the price of that underlying instrument often in the press you’ll hear journalists saying the derivatives market should be outlawed because they are just a form of legalized gambling and that they are no economic value this is not true derivatives markets have a number

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Of benefits that mean that they improve the world we live in and are generally good for society overall even for people who do not transact in derivatives the derivatives market reallocates risk from the risk of earth to those willing to take risk with the expectation of a reasonable return this ability to move risks around stimulates the economy as other wise

Businesses might stop trading once that reached a threshold of risk beyond which they were unwilling to go the derivatives market allows participants to hedge and manage their existing economic exposures derivatives are essential tools to determine both current prices and a best estimate of future prices derivatives can improve market efficiency for the underlying

Asset investors can buy an s&p 500 future for example and have much lower trading costs than if they were to buy all 500 stocks individually the use of derivatives can and does sometimes result in large losses often this can relate to an excessive use of leverage in a future video we’ll talk about the risks of trading derivatives and look at some large losses

That have happened in the past and see what can we learn from them well it looks like you’ve made it all the way to the end of the video if you found it useful please hit the like button below or tell your friends about these videos they might find them useful to do subscribe if you’d like to watch more of my videos when they come out in the next video we’re

Going to learn about our first derivative which is futures and forwards see you soon bye you

Transcribed from video
How are Financial Derivatives Traded? By Patrick Boyle

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