Exchange traded derivatives

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Exchange traded derivatives are derivatives contracts created with a standardized set of specifications in order to allow them to be traded on an exchange. Trading on an exchange is beneficial as it reduces credit risk for market participants, as buyers and sellers face the exchange (or Clearing House) as their counterparty as opposed to other market participants.

Credit risk (effectively the likelihood of a person or institution being able to pay a (future) liability) is important for participants in the derivatives market as most derivatives are structured to require a potential payment between the contracting parties at the maturity of the deal. For example, options that finish in-the-money need to be settled at maturity, as will most futures contracts if they held to end of their life. A clearing house will operate a mechanism called 'margining' that acts as a way to guarantee that the holder of the derivative will receive any payment they are owed at maturity. In this manner, derivatives that are traded on exchange will have substantially less credit risk than those that are traded in the over-the-counter (OTC) market.

The main types of exchange traded derivatives are futures (a contract to buy or sell at some price at some point in the future) and options (a contract granting the right to buy or sell at a certain price at a certain point in the future). Derivatives exist across all asset classes and trade on various different exchanges around the world. Commodity, equity, fixed income and FX derivatives are all available on exchange and in many cases markets for both futures and options (the two main derivative types) can be found on the same exchange.

Each exchange will have it's own set of rules for each type of derivative that it has listed to trade in it's marketplace. These rules and specifications ensure the derivative is 'standardized'. The standardization is important as it allows all participants to have confidence around what it is they are trading (and thus contracting to). It is also important to know the exact specifications of the derivative security before trading, as these will affect the price of the asset and the details of the contract into with the buyer and seller are entering.

Derivatives trade on exchanges all over the world with particular concentrations in Chicago, New York, London, Singapore, Hong Kong and Tokyo. It is common for an exchange to have a specialization in the derivatives of a particular asset class and this is often (although not always) related to physical underlying assets that have also historically traded heavily in that geographical area. For example, the London Metal Exchange (LME) is an exchange for non-ferrous metals based in London where much metal trading occurs. Similarly, the CME based in Chicago offers many agricultural and energy derivatives and has grown up based on the traditional trading of these assets that occurred in Chicago and is one of the biggest derivative exchanges in the world.

It is estimated that at the end of 2010 Q1 there will be 346,000 billion USD of outstanding notional in exchange traded derivatives across all asset classes1.

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