About Derivatives
In New Zealand there are three financial markets:
- the equities market
- the interest rate market (comprising bonds and interest rate products)
- the foreign exchange market.
Each of these financial markets can be further divided into:
- primary markets
- secondary markets
- derivatives markets.
Primary markets are where companies initially list or issue securities (bonds, shares etc) for sale, for capital raising purposes.
Secondary markets are where these securities are actively traded (bought and sold) by investors.
Derivatives markets are where derivative products are traded. Derivative products are formed or "derive" their value from securities which trade in the primary and secondary markets.
To have a successful primary market (where companies can raise capital successfully by issuing securities for sale) there needs to be an active secondary market where investors can buy and sell securities with ease, secure in the knowledge that they can sell their holdings quickly and at a fair price. Such an active market is described as a liquid market.
The futures and options (derivatives) market assists in the development of a liquid secondary market by providing an additional marketplace for investors and traders to eliminate or take on the risk that prevails in holding securities in the secondary market. Since futures and options can be traded at lower costs and therefore offer greater leverage, it is often the case that they are as liquid (active), or even more liquid than the secondary markets. This liquidity in turn attracts even more investors and traders, as market prices are fairer. The market is then deemed to be an efficient market.
Market example
When Telecom listed on the NZSX Market there was a need to issue new shares for sale to raise capital. We will follow this share issue through the three markets.
Primary market
The new shares were initially offered to the public who subscribed for the shares under Telecom's prospectus and investment statement.
Secondary market
Once the shares were fully subscribed and listed, they were then able to be bought and sold among investors on the NZSX Market (the secondary market). They continue to trade there today.
Derivatives market
The third stage of the process is the introduction of derivatives based on the individual shares: NZX's Telecom share options contracts. These options are listed on the SFE which facilitates trading of the options among investors.
