DEFINITION of ‘Exchange Traded Derivative’
A financial instrument whose value is based on the value of another asset, and that trades on a regulated exchange. 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.
BREAKING DOWN ‘Exchange Traded Derivative’
Exchange traded derivatives are especially suited for the retail investor because of the following features that distinguish them from OTC derivatives.
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 counter-party 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 counter-party to the derivative transaction may default on its obligations.
Exchange traded derivatives are not favoured 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, but this may be a hindrance t large institutions, who may not want their trading intentions known to the general public.
Another defining characteristic of exchange traded derivatives is their mark-to-market feature, wherein gains and losses on every derivative contract is 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.