Trading and Settlement of Derivatives

Trading of Derivatives –

Derivatives are usually traded Over the Counter (OTC) or on Centralised Exchanges. Futures and Options are traded on Exchanges and others are mostly traded OTC. Exchange-traded derivatives are standardized agreements and these are backed by a clearing house that ensures both parties honour their obligations without any defaults. OTC agreements can be customized as per the needs of the parties, but default risk is a significant concern.

The difference between OTC and Exchange-traded markets is covered in the next chapter.

Settlement of Derivatives –

The derivative contracts can be settled in 2 ways –

• Physical Settlement – the underlying is exchanged between the seller and the buyer for full payment of contract value. Jill will deliver the Gold and Jack will pay her the $100.
• Cash Settlement – only net gains and losses are settled between the parties. The underlying is not exchanged between the parties. Most contracts are cash-settled.

If the parties choose to settle in cash, the Settlement Amount will be the difference between the current price (spot-market price) and the agreed contract-price. The buyer will pay the difference if the current price is lower than the agreed upon price and the seller will pay the difference if the current price is higher than the agreed upon price.

• If the actual price is $120, we know that Jack has a positive value of $20 and Jill has a negative value of $20. So, Jill will pay $20 to Jack, and the contract is settled.
• If the actual price is only $90, Jack is losing $10 and Jill is gaining $10. So, Jack will pay the difference of $10 to Jill.

Cash settlement is similar to a bet – the loser pays the gainer.