Over-the-counter (OTC) Market And traditional Exchange Market
The over-the-counter (OTC) market is used for large trades, and a typical OTC trade is conducted over the phone. Terms are not set by an “exchange,” giving traders more flexibility to negotiate mutually agreeable terms. The OTC market has more credit risk. Exchanges are organized to eliminate credit risk.
Advantages of over-the-counter trading:
- Terms are not set by any exchange.
- Participants have flexibility to negotiate.
- In the event of a misunderstanding, calls are recorded.
Disadvantages of over-the-counter trading:
- OTC trading has more credit risk than exchange trading. Exchanges are organized in such a way that credit risk is eliminated.
Options, Forwards, And Futures Contracts
A call option gives its holder the right to buy a specified number of shares of the underlying security at the given strike price, on or before the option contract’s expiration date, while a put option is the right to sell a fixed number of shares at a fixed price within a given prespecified time period.
A forward contract is an agreement to buy or sell an asset at a pre-selected future time for a certain price.
A futures contract is a more formalized, legally binding agreement to buy or sell a commodity or financial asset in a pre-designated month in the future, at a price agreed upon today by the buyer/seller.
Payoff
The payoff on a call option to the option buyer is calculated as follows:
CallT = max (0, ST − X)
where:
ST = stock price at maturity
X = strike price of option
The payoff on a put option is calculated as follows:
PutT = max (0, X − ST)
where:
ST = stock price at maturity
X = strike price of option
The payoff to a long position in a forward contract is calculated as follows:
payoff = ST − K
where:
ST = spot price at maturity
K = delivery price
Derivatives Traders
There are three broad types of traders: hedgers, speculators, and arbitrageurs.
Hedging is used for risk management. The hedger has a risk associated with the underlying commodity or financial instrument. The use of futures helps mitigate those risks.
Speculating does not mitigate risk but is risk-taking. Profit is the motive of the speculator since he has no risk before entering into the futures transactions.
Arbitrage ensures that futures and cash markets stay in balance. Buying in the cheaper market and selling in the overpriced market will bring markets back into alignment and provide a riskless profit for an arbitrageur.
Hedging Strategies
Hedgers use derivatives to control or eliminate a financial exposure. Futures lock in the price of the underlying security and do not allow for any upside potential. Options hedge negative price movements and allow for upside potential since they have asymmetric payouts.
Speculative Strategies
Speculators use derivatives to make bets on the market. Futures require a small initial investment, which is the initial margin requirement. Futures contracts can result in large gains or large losses as futures have a symmetrical payout function.
Arbitrage Opportunities
Arbitrageurs seek to earn a riskless profit through the discovery and manipulation of mispriced securities. Riskless profit is earned by entering into equivalent offsetting positions in one or more markets. Arbitrage opportunities do not last long as the act of arbitrage brings prices back into equilibrium quickly.
Risks From Using Derivatives
Derivatives are versatile instruments and can be used for hedging, arbitrage, and pure speculation. Controls need to be carefully established to prevent misuse of derivatives. Risk limits must be carefully established and scrupulously enforced.
