Derivatives Contract

A derivative contract is a document, which reflects a contractual agreement on the evolution of an asset, called an underlying asset . 

The most widespread contract model in hedging and leveraging financial operations is the ISDA (International Swaps and Derivatives Association).

These contracts have to define exactly both the general and specific terms that influence operations. There should be significant changes in the price for a  split ,  capital increases, quotation suspensions, interest rates charged and their differentials, the methods applied to avoid breaches between the parties, clearing houses, forms and settlement time, deposit , financial entities that allow exchange.

There is a wide variety of derivative contracts on  currencies , metals,  raw materials ,  indices,  stocks ,  bonds ,  interest rates.

On the other hand, there are models of financial contracts of non-organized OTC (Over the counter) markets, where there is no clearing house, being bilateral agreements that are negotiated with counterparts, usually market makers where, unlike organized markets, the investor You will not have to deposit guarantees, existing netting and  collateral agreements with the other party involved in the negotiation. These types of contracts have a higher risk, since their assets are difficult to value and control.

This market has grown exponentially in recent years, and has been one of those responsible for the economic crisis expansion. Therefore, regulators are trying to limit and control the operations made to measure for each operation or client, thanks to the new Dodd-Frank law that establishes that every OTC financial contract is subject to supervision by financial regulators but, nevertheless, is not collects the control of the net positions of the brokers in the market or the percentage of coverage of the positions of their clients, there may be conflicts of interest between the parties, in many cases, contrary to investors and with price differentials well above of those in the market.

On the other hand, it is important to highlight that in the US 90% of OTC derivatives are in the hands of four banks.

Types of financial derivatives

There are different types of financial derivatives:

  • Futures: They are traded in organized markets. They are standardized contracts.
  • Forward: They are traded in OTC markets. They are term contracts settled by differences.
  • Options:A premium is paid that represents a proportion of the value of the option, the investor has the right to buy or sell an asset at an agreed price. Generally, options are listed on organized markets, although it is increasingly common to see OTC options.
  • Swaps: They arequoted in OTC markets, have a future maturity and are settled by the difference between the future prices of the underlying asset and the price that was agreed.

In order to negotiate derivative products, the provision of guarantees is necessary. In the case of organized markets, the investor will have to cover the market guarantees, however, in non-organized markets, the investor will have to cover the guarantee established by the counterparty.

Leave a Comment