Derivatives Market

 

Definition

A derivatives market is a system of financial contracts whose value is based on another asset. A derivative does not exist independently – its price is derived from an underlying instrument.

Main types: futures, options, forwards, swaps.

Purpose

Derivatives allow to:

– Hedge risk

– Transfer risk to another party

– Use leverage

– Create complex strategies

For example, an airline can lock in the price of fuel through a futures contract. A bank can hedge interest rate risk through a swap.

Exchange-Traded vs. Over-the-Counter (OTC)

Exchange-traded derivatives are standardized and cleared through a central clearing house.

OTC derivatives are concluded directly between parties.

The OTC market is much larger than the exchange-traded market but less transparent.

Role in the Financial System

Derivatives allow for the distribution of risk within the system. They are a tool for stabilization but can also create systemic risk when excessive leverage is used.

Risks

Credit risk (OTC)

Complexity of structure

Leverage

Lack of transparency

Summary

The derivatives market is a risk management infrastructure. It does not create new value but reallocates financial risks among participants.