Exchange traded derivative
Also written ETD · Exchange-traded derivative (ETD) · Exchange traded derivatives
A derivative traded on an organised exchange on standardised terms, with prices set by anonymous auction and performance guaranteed by a clearing corporation — as against a bilateral, customised OTC contract.
In plain language
There are only two places a derivative can live.
It can be negotiated directly between two parties — over the telephone or through electronic media — with the terms tailored to what those two want. That is the over-the-counter market, and a forward contract is its simplest form.
Or it can be traded on an exchange, on terms the exchange has already fixed: lot size, expiry, tick, settlement method. Everything is decided except the price, and the price is discovered by an anonymous auction between buyers and sellers who never learn each other's names.
The second arrangement gives up customisation and gets back something bigger: a clearing corporation steps between the two sides and guarantees that the contract will be performed. Nobody has to assess anybody's creditworthiness.
How it works
The workbook lists the OTC market's features, and the exchange-traded market is the negative of each:
| OTC derivative | Exchange traded derivative | |
|---|---|---|
| Terms | Tailor-made to the counterparties | Standardised by the exchange |
| Counterparty risk | Decentralised, sits inside each institution | Guaranteed by the clearing corporation |
| Position limits, leverage, margin | No formal centralised limits | Set and enforced centrally |
| Risk management rules | None formal for market stability | Margining, MTM, surveillance |
| Disclosure | Private, little or none to the market | Prices and open interest public |
| Regulation | Less regulated | Fully regulated |
The workbook's explanation for the lighter OTC regime is worth remembering: those transactions happen privately among qualified counterparties who are supposed to be capable of taking care of themselves. Its participants are banks, financial institutions, hedge funds, corporations and high net-worth individuals — not retail.
India's exchange-traded equity derivatives history is examinable: index futures on the Nifty and Sensex from June 2000, index options from June 2001, stock options from July 2001, stock futures from November 2001, and MSEI from February 2013.
The formula
Contract value = Lot size × Price
Initial margin = Margin percentage × Contract value
Leverage = Contract value ÷ Margin paid
A worked example
A trader takes one lot of Nifty October futures at 25,006.60, lot size 65, against a bilateral forward on the same exposure.
Contract value = 65 × 25,006.60 = Rs 16,25,429
Margin at 20% = Rs 3,25,086
Leverage = 16,25,429 ÷ 3,25,086 = 5×
On the exchange. The Rs 3.25 lakh goes to the clearing corporation, the position is marked to market daily, and if the counterparty on the other side defaults the trader is still paid — the clearing corporation guarantees settlement. He can also square off at any moment by trading the offsetting contract with anyone at all, because the contract is standardised and fungible.
Over the counter. The same exposure written as a forward with a bank needs no margin at all — attractive until you notice the consequences. There is no daily settlement, so a loss accumulates silently until maturity. There is no guarantor, so if the bank fails the trader has a claim, not a payment. And there is no second buyer for a contract written to his own specification: to get out before maturity he must go back to the same bank and accept its price.
Put a number on the difference. If the index falls to 24,000 by expiry:
Loss = (25,006.60 − 24,000) × 65 = Rs 65,429
On the exchange, that Rs 65,429 has already been collected in daily MTM instalments and the exposure never built up. On the forward it is a single payment falling due on one day, from one counterparty, with nothing behind it but that counterparty's balance sheet. The contract economics are identical; the credit risk is not.
Why NISM asks about it
Chapter 13.5 (Types of Derivatives Market) sets out the OTC-versus-exchange contrast feature by feature, and Chapter 13.2 gives the Indian launch dates. Expect a "which of these is true of OTC derivatives" question — the answer usually being customisation or decentralised counterparty risk — and a question on who guarantees performance of an exchange-traded contract: the clearing corporation.
Common exam traps
- The clearing corporation guarantees settlement, not profit. It removes counterparty risk, not market risk.
- Futures are standardised forwards. The workbook says so in terms: the economics are the same, the venue and the guarantee are not.
- "Less regulated" is not "unregulated". OTC derivatives in India sit under RBI and SEBI mandates depending on the underlying.
- Only the price is left to the market on an exchange. Lot size, expiry, tick and settlement are all fixed in advance.
- Standardisation is what creates liquidity. A tailor-made contract has exactly one possible buyer — the counterparty who wrote it.
- Get the launch sequence right: index futures 2000, index options and stock options 2001, stock futures November 2001.
Check yourself
1.In what order were these products introduced in India?
- a)Index options → Index futures → Stock futures → Stock options
- b)Index futures (June 2000) → Index options (June 2001) → Options on individual stocks (July 2001) → Futures on individual stocks (November 2001)
- c)Stock futures → Stock options → Index futures → Index options
- d)All four were launched together in June 2000
Show the answer
Answer: (b) Index futures (June 2000) → Index options (June 2001) → Options on individual stocks (July 2001) → Futures on individual stocks (November 2001)
"The exchange traded derivatives started in India in JUNE 2000 with SEBI permitting BSE and NSE to introduce the equity derivatives segment. To begin with, SEBI approved trading in INDEX FUTURES CONTRACTS BASED ON NIFTY AND SENSEX, WHICH COMMENCED TRADING IN JUNE 2000. Later, trading in INDEX OPTIONS COMMENCED IN JUNE 2001 and trading in OPTIONS ON INDIVIDUAL STOCKS COMMENCED IN JULY 2001. FUTURES CONTRACTS ON INDIVIDUAL STOCKS STARTED IN NOVEMBER 2001." The detail that catches most candidates is that options on individual stocks came BEFORE futures on individual stocks — July 2001 against November 2001. India began with the index, the broadest and hardest instrument to manipulate, and moved to single stocks only after a year of experience. Two legal changes had to come first: the SCRA amendment of 1999 bringing derivatives within securities, and the repeal in March 2000 of "a three-decade-old notification, which PROHIBITED FORWARD TRADING IN SECURITIES." MSEI joined the derivatives market much later, in February 2013.
Where this is taught
Free preparation for NISM Series VIIIRelated terms
- Clearing corporationThe entity that steps between every buyer and seller in the derivatives segment by novation, becoming the counterparty to both sides and guaranteeing that the trade settles.
- DerivativeA contract whose value is derived from the value of something else — the underlying — rather than from anything the contract itself owns or produces.
- Forward contractA bilateral, over-the-counter agreement between two parties to buy or sell an asset on a fixed future date at a price agreed today — customised to suit them, and binding on both.
- Futures contractA standardised forward traded on an exchange, where the exchange fixes every term except the price and the clearing corporation guarantees settlement, so neither side carries the other's default risk.
- Mark to MarketThe daily settlement of a futures position at that day's closing price, so gains and losses are paid in cash every evening instead of accumulating until expiry.
- Initial marginThe deposit both the buyer and the seller of a futures contract must place before the position is accepted, sized to cover a 99% worst-case one-day loss on that position.