TYPES OF DERIVATIVE MARKETS
Broadly, there are two types of derivatives markets:
- Over-the-counter market (OTC): In the OTC market, the derivatives contracts are negotiated privately between parties. There might be a middle party who facilitates such negotiation for commission. There are no specific or particular contract specifications.
- Organized exchange: In organized exchanges, such as Chicago Mercantile Exchange (CME), New York Mercantile Exchange (NYMEX), and Chicago Board Options Exchange (CBOE), the contract specifications for listed derivatives are standardized. Buyers and sellers in such exchanges trade following the rules specified by the change. Order execution through an exchange facilitates transparency, liquidity, and price discovery.
TYPES OF DERIVATIVE INSTRUMENTS
There are many kinds of derivative instruments. Broadly, we can categorize it into the following types:
- Forwards: a contractual agreement between two parties over-the-counter to buy or sell a product on a future date at a pre-determined price negotiated today. You do not pay anything upfront.
- Futures: a contractual agreement between two parties in an organized exchange to buy or sell a product on a future date at a pre-determined price negotiated today. You do not pay anything upfront, but there is a margin requirement.
- Options: a contractual agreement between two parties over-the-counter or in an organized exchange to buy or sell a product on a future date at a pre-determined price negotiated today. You must pay a premium upfront.
- Swap: a contractual agreement between two parties over-the-counter to exchange cash flows on a notional principal of an underlying on future dates periodically until maturity.