The Global Derivatives Market - An Analysis

By M. Isi Eromosele

Derivatives are an important class of financial instruments that are central to today’s financial and trade markets. They offer various types of risk protection and allow innovative investment strategies.

The derivatives market is predominantly a professional wholesale market with banks, investment firms, insurance companies and corporations as its main participants.

By and large, the derivatives market is safe and efficient. Risks are particularly well controlled in the exchange segment, where central counterparties (CCPs) operate very efficiently and mitigate the risks for all market participants. In this respect, derivatives
have to be distinguished from structured credit linked security such as collateralized debt obligations that triggered the financial crisis in 2008.

Derivatives are totally different from securities. They are financial instruments that are mainly used to protect against and manage risks, and very often also serve arbitrage or investment purposes, providing various advantages compared to securities. Derivatives come in many varieties and can be differentiated by how they are traded, the underlying they refer to, and the product type.

A derivative is a contract between a buyer and a seller entered into today regarding a transaction to be fulfilled at a future point in time, for example, the transfer of a certain amount of US dollars at a specified USD-EUR exchange rate at a future date.

Over the life of the contract, the value of the derivative fluctuates with the price of the so-called “underlying” of the contract - in this case, the USD-EUR exchange rate. The life of a derivative contract, that is, the time between entering into the contract and
the ultimate fulfillment or termination of the contract, can be very long – in some cases more than ten years.

Given the possible price fluctuations of the underlying and thus of the derivative contract itself, risk management is of particular importance.

Derivatives must be distinguished from securities, where transactions are fulfilled within a few days. Some securities have derivative-like characteristics - such as certificates, warrants, or structured credit-linked securities; but they are not derivatives.

Derivatives make future risks tradable, which gives rise to two main uses for them. The first is to eliminate uncertainty by exchanging market risks, commonly known as hedging. Corporations and financial institutions, for example, use derivatives to protect themselves against changes in raw material prices, exchange rates, interest rates etc.

They serve as insurance against unwanted price movements and reduce the volatility of companies’ cash flows, which in turn results in more reliable forecasting, lower capital requirements and higher capital productivity. These benefits have led to the widespread use of derivatives: 92 percent of the world’s 500 largest companies manage their price risks using derivatives.

The second use of derivatives is as an investment. Derivatives are an alternative to investing directly in assets without buying and holding the asset itself. They also allow investments into underlyings and risks that cannot be purchased directly.

Examples include credit derivatives that provide compensation payments if a creditor defaults on its bonds, or weather derivatives offering compensation if temperatures at a specified location exceed or fall below a predefined reference temperature.

Derivatives also allow investors to take positions against the market if they expect the underlying asset to fall in value. Typically, investors would enter into a derivatives contract to sell an asset (such as a single stock) that they believe is overvalued, at
a specified future point in time.

This investment is successful provided the asset falls in value. Such strategies are extremely important for an efficiently functioning price discovery in financial markets as they reduce the risk of assets becoming excessively under- or overvalued.

The derivatives market has grown rapidly in recent years as the benefits of using derivatives, such as effective risk mitigation and risk transfer, have become increasingly important. Europe is by far the most important region for derivatives that have become a
major part of the European financial services sector.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance
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