Purpose of derivatives market & how derivatives help in hedging or eliminating risk

                      All praise is due to Allah the most beneficent and the most merciful may Peace, mercy and blessing of Allah of Allah (S.W.T) be upon him, his family, his sahabas and those who follow him with righteousness until last day amen.  Before going further I will first and foremost define what is a Derivative..? Derivative is a merely a contract that give the right to the holder to purchase or vend a commodity at specific future date for a preset price. As a result, even though the bond or a stock has an intrinsic value (the bond or a stock denotes a claim to some of the income stream or asset), a derivative has no intrinsic value.  Its value is “derived” from the underlying asset.

         What is a Derivative markets..? Derivative markets are a comparatively new phenomenon, however are unique of the most quick growing asset classes. Presently, there are about 300 million derivative contracts outstanding with a market value of around $50 Trillion whereas equity trading is centered in New York (NYSE, NASDAQ), derivative markets are centered in Chicago (CME, CBOT, CBOE).

           Derivatives can be used for hedging, arbitrage and speculating purposes. Through a hedge, a stakeholder can defend himself counter to risk he is exposed to. Risk that can be hedged using derivatives can be actions in market variables (e.g. share, commodity prices, exchange and interest rate,) such as credit risk.  The Derivatives is also used as a means to speculate on the movement of creditworthiness or on market variable. Opportunists(speculators) enhance the liquidity to the market by taking on the  outlook on the direction of the movement; which is frequently known as as taking a bet, can  be of course be called taking risk.

                        Subsequently, there are two parties that involved in a derivative dealing, the speculator needs to find somebody who holds on the reverse view or would like to transfer a particular risk. Lastly, the derivatives can be used as arbitrage. The arbitrage opportunity is a taking advantage of price variances between the markets. Derivatives can be joint to replicate other financial mechanisms; as a result they can be used to "link" the markets by removing pricing incompetence between them the markets.

                       Derivatives, as a result play an important role in price discovery. For example, they provide the market's outlook on future growths in the market variables. They may also grant access to a view on the defaulting risk of the reference entity, on a corporation or an independent debtor, or of a particular section of the recognition (Credit) market. Thus, derivatives tolerate for pricing of risk that might otherwise be so demanding to price for the reason that the underlying assets are not adequately traded.

        Some of the purposes of a derivative Market in our society or community can be broadly categorized into five collections. at large are as follows:

1)      The Market structure

2)      The Trade execution

3)      The Trade confirmation:

4)      The Clearing:

5)      The Transparency

6)      The Transparency on positions 

       I.            The Risk characteristics

    II.            The Risk management

 III.            The CCP clearing – Swap Clear

                        Firstly, the Market structure, as a derivative contract can be either merchandised in a public location, which is a derivatives exchange, otherwise privately over-the-counter (OTC) that is off-exchange. The over-the-counter (OTC) derivatives markets have been characterized via suppleness and tailor-made products. This content the demand for the bespoke deals tailored to the specific risks that the consumer (user) wants to hedge. Exchange-traded derivative deals, on the other hand, are by definition standardised contracts.

                        Secondly, The Trade execution, Trade execution comes about after two counterparties come to an agreement to a deal. On-exchange, instructions are in line automatically with the derivative exchanges' order books. The over-the-counter (OTC) execution may take a range of forms, contingent on deals' standardisation and market preference, Example. The Occurring by electronically on, phone or "private" exchanges (e.g. inter-dealer networks).the electronic trading has improved quickly in latest years, driven in part via the arrival of hedge funds, which have diverse trading requests compared to e.g. corporates.

                        Thirdly, The Trade confirmation, after the execution, the terms of the trade necessity to corroborated (affirmation) and confirmed. The on-exchange, this occurs automatically within the exchange's matching system. As regards OTC, the most standardised (vanilla) over-the-counter (OTC) deals use electronic verification and confirmation third-party facilities (e.g. DTCC's Deriv /SERV, Markit Wire etc.).

 

                          Fourthly, The Clearing, Divergent to equity markets, where the post-trade aspects (e.g. exchange of cash and transfer of ownership) are completed quickly (less than 2/3 days), derivative deals involve lengthy-term exposure, and for instance derivative deals may last for many years. This leads to the build-up of vast claims between counterparties, with of course the risk of a counterparty default. Clearing is the purpose via which these risks are managed over time. On-exchange, clearing is done on a Central Counter-party (CCP).Over-counter (OTC), clearing is generally done bilaterally between the bashes involved but progressively on a central counter-party (CCP).

                        Moreover, the Transparency, whereas the exchange-traded derivatives leave a transparent path in terms of the positions, prices and exposures, in the mostly over-the-counter (OTC) market for derivatives, the information available to market partakers(participant) and overseers is restricted. In the previous sections, it has been accentuated that neither market partakers nor supervisors had a complete opinion of the market. More transparency to regulators, mostly on positions, might progress the resilience of the financial system. The situation is described in the first part of this segment. Moreover, transparency might also progress market efficiency (in precise through price transparency) aiding in order to become aware of possible market exploitations (through transaction reporting) and to reduce the frictional costs in the market. These latter aspects are dealt with in the second and third part of this subdivision.

                           Furthermore, the Transparency on positions:

       I.                             The Risk characteristic, are like other over-the-counter (OTC) derivative markets, the credit derivatives markets are constructed on products that bind together institutions and markets in ways that are demanding to comprehend and survey both systemic and at the institutional level. Whereas CDS are relatively lesser compared to other over-the-counter (OTC) derivatives markets, they are particularly important in terms of risk.

    II.                            The Risk management, are Like other over-the-counter (OTC) derivatives, the risk management happens at various levels.  Firstly, the sales personnel operate on the source of trader's assessment of appetite for entering into a contract with a particular counterpart (based on assessment of risk allied with a particular counter-party). Secondly, the traders hedge the exposure they take in that deal. Thirdly, by providing of collateral. The interest rate over-the-counter (OTC) market has, as delineated above, a CCP in place. The   Risk management thus differs contingent on whether rate contracts are cleared or not. 

 III.                             The central counterparty (CCP) clearing – Swap Clear, Swap Clear is presently the dominant provider of CCP clearing facilities for interest rate swaps. Operated via LCH. Clear net Ltd, it is in place since 1999. Legal deals were already adequately standardised under the ISDA master contract and the terms of the deals did not necessity to further standardisation to allow CCP clearing. Swap Clear has thrived even though deals remain mainly tailored to bespoke requests. The required prerequisites for CCP

The clearing in the rate space were:

(i)                 The confirmed matched trade,

(ii)                (ii) The risk engine, and

(iii)              (iii) The default

                          The management process. In addition are more concerned about the liquidity has also contributed to enabling CCP clearing in contrast with CDS, where liquidity is much more disjointed, with thousands of reference individuals, than for IRS, where key currencies are inadequate to a dozen.

                          In conclusion derivatives are used as a speculating, hedging, and arbitrage drives. By means of a hedge, a stakeholder can defend himself against risk he is exposed to. The Risk that can be hedged by means of derivatives can be activities in market variables. In or der to minimize or eliminate the risk in the market.

 

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