Understanding the derivatives market – key classification

Understanding the derivatives market – key classification

After we covered the history of financial derivatives, it is now time to discuss the types of derivatives and why it is essential to distinguish one from another.

Generally, the derivative market is comprised of two categories: OTC (over-the-counter derivatives) and Exchange-Traded.

OTC derivatives include contracts established directly and privately between two or even more counterparts without being listed on stock exchanges. Examples of OTC derivatives: forwards and swaps.

On the other hand, Exchange-Traded derivatives are found on stock exchanges, where even small investors can trade because these contracts are public. Examples of Exchange-Traded derivatives: futures and options contracts.

Since both OTC and Exchange-Traded derivatives are huge topics to cover, we will be tackling them separately in standalone articles. Until then, let's move forward with our classification:

OTC Derivatives

Swaps

Swaps give an investor the possibility to exchange assets or debts for another similar value, to reduce the risks for involved parties.

Another connection to the crisis of 2008: the Credit Default Swap sold as insurance against the default of the municipal bonds has had a significant role in the economic collapse. Generally, excessive leverage and poor risk management do lead to lots of trouble.

Forwards

Forwards are a type of OTC financial derivative used to buy or sell a security at a previously agreed-upon value on a pre-determined date in the future. Forwards can act as hedging tools for managing investment risks, similar to other types of derivatives.

Exchange-Traded Derivatives

Futures and Options Contracts

Moving to exchange-traded derivatives, we have the two major types here: futures and options contracts.

A future is a contract facilitating one security for another at a pre-set exchange rate and date. Traders can use futures for hedging purposes, among other roles.

Options give people the right, but not the obligation, to exchange one security for another at a pre-determined price and date before the expiry date of that security. You can find additional details about all the above derivatives here.

There are other types of derivatives deserving special mentions: CDOs and CFDs.

CDOs

CDOs stand for Collateralized Debt Obligations - financial instruments which base their value on the repayment of the loans offered. CDOs are securities holding various types of debt, such as mortgage-backed securities or corporate bonds, which are then sorted out into different risk levels and sold to investors.

These contracts were blamed for the economic crisis of 2008. We recommend watching either “The Big Short” or “Inside Job” movies to fully understand how they worked – they’re both excellent films!

CFDs

The CFDs (contracts for difference) allow traders to purchase a certain number of units of a particular security, depending on the decrease or rise in its value. The gains (or losses) will vary depending on the fluctuations in the prices of those securities.

With CFDs, you can open long positions if you think the price will go up or short positions if you think the price will go down – something that you cannot do if you decide to invest in a stock market.

Essentially, CFDs fall into the derivatives category of financial instruments, as they are linked to securities like #shares, #indices, #currency pairs or #cryptos.

Here at CAPEX.com, you get the opportunity to try out trading on more than 2.100 CFDs, grouped in 8 asset classes. To get started, create an account here!

In the final article of our series on the derivatives market, we will be covering the various advantages and disadvantages of each category. Until then, stay tuned to our Featured Articles section!

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