The nature of derivatives

Derivatives are one of the most important financial instruments in the global economy and form an extremely significant, complex and large financial market. Their contribution to the Global Financial Crisis cannot be negated.

A derivative is a type of financial instrument whose value is derived (based upon) the value of an underlying asset, index, rate or reference point. Derivatives involve the transfer of risk from one party to another and are used as a form of risk management. Derivatives are financial products under the Corporations Act 2001 (Cth) and regulated under Ch 7 (Financial services and markets). The derivatives markets consist of both exchange-traded and over-the-counter (OTC) derivatives.

This guidance note sets out where derivatives sit in the global economy, who uses derivatives, what are the underlying reference points for a derivative and describes the commercial drivers for entering into derivative transactions:

• • speculation;
• • hedging;
• • arbitrage; and
• • exposure to asset classes.

The global derivatives market is largely driven by standard documentation developed by the International Swaps and Derivatives Association (ISDA). Within Australia the Australian Financial Markets Association (AFMA) is the relevant trade association.

See The nature of derivatives.

Over-the-counter and exchange traded derivatives

There are two broad types of derivatives, Over the Counter (OTC) derivatives and Exchange Traded Derivatives (ETD’s). An OTC derivative is a privately negotiated contract between two parties. An ETD is bought or sold on an exchange like the ASX. Documentation differs between these types of derivative. All ETD derivatives are cleared as are most OTC derivatives however some OTC derivatives may not be cleared which may involve a greater risk than a cleared derivative. Derivatives will be settled either by cash or by physical delivery.

See Over-the-counter and exchange traded derivatives.