The derivatives market is a financial market for financial instruments ‘derived’ from underlying assets. This means the financial instruments (in this case different sorts of contracts) traded on this market represent an agreement for a specified asset (the ‘underlying asset’) to be transferred/paid for at a later point at an agreed time. Essentially, derivatives contracts are IOUs for things like commodities, equities (ownership in a company, stocks and shares), bonds, interest rates and currencies!
Derivatives can feature across all asset classes and on both the over-the-counter (OTC) market (a platform for two parties to trade an asset without going through an exchange) and the exchange-traded market, in which a trade must go through an exchange such as the London Stock Exchange.
Examples of derivatives include:
Options – A contract which grants its owner the option and right to buy or sell an asset at a certain price on or before a certain date, known as the maturity date. It’s important to note that this is the right, but not the obligation, to buy or sell.
Futures or forward contracts – contracts between two parties who agree to buy an asset and exchange it at a future date which is decided on the day the trade (agreement to buy/sell) is made.
Working with derivatives…
Investment banks have professionals who specialise in this market. In the front office, the area of the bank that generates capital for the bank and its clients, there are of course the traders and salespeople. The salespeople liaise and correspond with clients, providing and advice and recommendations for buying and selling on the market, and taking in orders to buy or sell derivatives, and the traders will execute this. There are also top class technology experts and quantitative analysts (quants) in the front office, developing software and applications to monitor derivatives products and price them/
In the middle office there are risk managers specialising in derivative/products. Derivatives are exposed to all sorts of potential risks that have to be mitigated to keep the client and the bank as secure as possible.
In the back office of an investment bank there are clearing and trade settlement roles. Professionals here carry out post trade duties and make sure that the correct information, ownership details, cash payments and assets specified in the contract are made accurately and on time.