Derivatives Fundamentals and Market Structure
Derivatives are contracts whose value derives from an underlying asset, reference rate, index or event, so they are not a separate asset class. This domain tests definitions, commercial purpose and market plumbing: who trades, where trades execute, how they are cleared and what regulation requires.
The four contract families
- Futures: standardised, exchange-traded, margined and usually cleared.
- Forwards: bespoke, OTC, settled at maturity.
- Options: a right, not an obligation, bought with a premium.
- Swaps: exchanges of cash flows over time on a notional principal.
Underlyings include equities, interest rates, FX, credit, commodities and indices.
Exchange-traded versus OTC
Exchange-traded contracts have standardised terms, transparent prices, daily margining and a central counterparty (CCP) that interposes itself between buyer and seller. OTC contracts are negotiated bilaterally, can be tailored to a precise exposure, and carry bilateral counterparty credit risk unless cleared. Post-2008 reform pushed standardised OTC derivatives into central clearing and trade repositories: EMIR in the EU and UK, Title VII of Dodd-Frank in the US, with MiFID II/MiFIR adding transparency. Clearing reduces bilateral risk but concentrates it in CCPs and creates initial and variation margin calls.
Participants and uses
Hedgers transfer price risk, speculators accept it for expected return, arbitrageurs enforce pricing relationships, and market makers supply liquidity. Uses include hedging, speculation, arbitrage, price discovery and leverage.
Worked example: leverage and margin
An investor buys 10 FTSE 100 futures at 7,500, with a contract value of £10 per index point. Notional = 10 × 7,500 × £10 = £750,000. Assume 8% initial margin, so £60,000 is posted. A 1% index rise (75 points) gains 75 × £10 × 10 = £7,500, a 12.5% return on margin; a 1% fall loses the same. Margin, not notional, determines day-to-day cash at risk, and the notional itself is never paid.
Marks-losing traps
- Treating “derivative” as an asset class rather than a contract.
- Equating OTC with unregulated, or exchange trading with zero risk.
- Confusing notional with margin or market value.
- Forgetting that variation margin is a daily cash flow, not a fee.