1 Overview of Derivatives
Learning objectives
Section titled “Learning objectives”Understand what derivatives and structured products are, identify their underlying asset classes and uses, distinguish exchange-traded from OTC products, and place Singapore’s derivatives market in context.
1.1 Introduction
Section titled “1.1 Introduction”A derivative is a contract whose value is derived from an underlying asset, reference rate, index, basket, event or outcome. The underlying may be physical (commodity), financial (share, bond, currency), an index or a rate. Core families are futures, forwards, swaps and options. Products may combine these into exotic derivatives or structured investments.
The derivative itself normally does not give ownership of the underlying. It can instead create a synthetic exposure, alter cash-flow timing or currency, separate a desired risk from an unwanted one, or transfer risk between parties. Main uses are:
- Hedging: reduce the effect of adverse price, rate, currency or credit movements; the residual is basis or other hedge risk.
- Speculation: take a view on direction, volatility, yield curve, correlation or credit with leverage.
- Arbitrage: exploit a temporary pricing inconsistency between markets or instruments.
- Repackaging/customisation: combine debt, deposits, options or swaps to produce a specified yield, participation, protection, conversion or maturity.
1.2 Underlying asset classes for derivatives and their uses
Section titled “1.2 Underlying asset classes for derivatives and their uses”Foreign exchange
Section titled “Foreign exchange”FX derivatives include spot/forward contracts, currency futures, FX swaps, currency options and non-deliverable forwards (NDFs). NDFs are particularly useful where a currency is restricted: the notional is not physically exchanged and the difference between the contracted rate and fixing rate is cash-settled. FX instruments hedge import/export receipts, foreign debt, investment currency and translation risk; they also allow views on relative currency strength.
Money-market and short-term interest rates
Section titled “Money-market and short-term interest rates”Underlying instruments include Treasury bills, interbank deposits, commercial paper, negotiable certificates of deposit and repos. Derivatives reference benchmark rates such as SIBOR (SGD) and, historically, LIBOR (other currencies); LIBOR has been phased out and replaced for USD by benchmarks such as SOFR. Short-rate futures, FRAs, caps, floors, collars and swaps manage or speculate on short-term rates.
Fixed income and credit
Section titled “Fixed income and credit”Underlying instruments include government and corporate bonds, stripped/zero-coupon bonds, mortgage-backed securities (MBS), collateralised debt obligations (CDOs) and credit default swaps (CDS). Credit quality, liquidity, maturity, embedded options and sovereign conditions matter. A CDS separates credit protection from ownership of the bond; the global financial crisis illustrated how leverage, opacity and counterparty concentration can amplify credit risk.
Equities and equity indices
Section titled “Equities and equity indices”Equity derivatives include single-stock and index futures, options, warrants, swaps and CFDs. They provide upside or downside exposure, portfolio hedging, index/sector allocation, dividend or volatility strategies and synthetic long/short positions without direct ownership. Index construction matters: an index may be price-weighted, capitalisation-weighted or based on another methodology.
Commodities
Section titled “Commodities”Agriculture, energy and metals are traded through futures, forwards, options, swaps, warrants, ETFs and CFDs. Prices are affected by supply/demand, storage, transport, seasonality, weather, geopolitical events, the USD and interest rates. Precious metals may act as safe-haven assets. A commodity derivative may be cash-settled even though the underlying market is physical; storage and convenience yield are therefore relevant to pricing.
1.3 Exchange-traded derivatives
Section titled “1.3 Exchange-traded derivatives”Exchange-traded derivatives have standardised contract terms, transparent quotes, a central clearing house, published margin rules and an organised secondary market. Standardisation improves liquidity and price discovery. Daily mark-to-market and margining reduce the build-up of unsecured exposure. The clearing house becomes the buyer to every seller and seller to every buyer, reducing bilateral counterparty risk but not eliminating market, liquidity, margin or clearing-system risk.
Typical characteristics are fixed contract size, multiplier, tick size, contract months, trading hours, price limits, last trading day, settlement method, delivery/eligible asset and position limits. Positions are usually closed by an offsetting trade; a product may instead be cash-settled or physically delivered.
1.4 OTC-traded derivatives
Section titled “1.4 OTC-traded derivatives”OTC products are negotiated bilaterally or through dealers. They can be tailored by notional, maturity, strike, barrier, observation dates, settlement currency, underlying, collateral and exercise terms. Customisation is valuable when an exchange contract does not match the exposure, but it creates counterparty, liquidity, valuation/model, documentation, legal, operational and close-out risks.
Post-global-financial-crisis reforms include moving standardised OTC derivatives to exchanges or electronic platforms where appropriate, central clearing, trade reporting to repositories and higher capital requirements for uncleared trades. A CCP reduces bilateral counterparty exposure but introduces clearing-member, collateral and default-management considerations.
1.5 Structured products
Section titled “1.5 Structured products”Structured products combine a principal component (deposit, bond, fund or other instrument) with one or more derivatives. They can offer yield enhancement, capital preservation at maturity, participation, a discount, a range payout, leverage, currency conversion, market access or a hedge. The apparent benefit is paid for through capped upside, conditional principal, issuer exposure, illiquidity, complexity or an obligation to buy/sell an underlying.
Do not infer that “structured” means “safe”. Read the payoff formula, trigger, barrier, settlement currency, early termination clause, issuer/SPV, collateral, fees, tax and maximum loss. Ownership of the underlying normally does not pass to the investor merely because the product references it.
1.6 Singapore derivatives market
Section titled “1.6 Singapore derivatives market”Singapore venues and marketplaces include SGX-DT, ICE Futures Singapore and APEX, and Singapore is an Asian hub for equity indices, commodities, interest rates and FX. SGX products include Asian index futures, commodity contracts, FX and rates products; exchange and clearing specifications determine the multiplier, trading hours, tick, margin, settlement and final price.
Singapore’s OTC FX market is material — SFEMC reported October 2020 average daily OTC FX swaps/options of approximately US$91 billion, affected by COVID-era market conditions. Use current market statistics for present-day decisions.
A MiFID II/regulatory scenario appears as a non-core application discussion: product governance requires a defined target market, product approval and review; KIDs/PHSs and risk disclosures must be available; transaction reporting and trading-venue obligations may apply; market makers may have obligations; distributors must understand the product, perform KYC/knowledge/suitability work, manage inducements and conflicts, and coordinate branch/head-office responsibilities. A Singapore/APAC distributor must not assume a foreign regime replaces Singapore obligations.
1.7 Summary and exam cues
Section titled “1.7 Summary and exam cues”Derivatives transfer rather than eliminate risk. The most examinable contrasts are standardised exchange versus customised OTC, CCP versus bilateral credit exposure, physical versus cash settlement, ownership versus synthetic exposure, and hedging versus speculation. Always identify the underlying, the direction of exposure, leverage/margin, settlement, liquidity and counterparty.