Derivative Instrument and Derivative Market Features | CFA Level I Derivatives

In this introductory lesson, we’ll cover the basics of derivatives, their underlying assets, and their uses. We’ll also discuss various types of derivatives like forwards, futures, swaps, options, and credit derivatives.

Understanding Derivatives and Their Features

At its core, a derivative is a financial instrument that derives its value from the performance of an underlying asset. Let’s explore the basic features of derivatives using a forward contract as an example:

• Underlying Asset: The asset on which the derivative contract is based, such as oil in our example.
• Long and Short Positions: The buyer of the contract (long) and the seller of the contract (short).
• Settlement Date (Expiry Date): The date when the future transaction takes place and the contract expires.
• Forward Price: The price agreed upon for the transaction on the settlement date.
• Contract Size: The number of units to transact.
• Price vs. Value: The distinction between the contract price and the value of the contract based on the spot price of the underlying asset at the settlement date.
• Deliverable vs. Cash-Settled Contracts: In deliverable contracts, the short physically delivers the underlying asset, while in cash-settled contracts, only the gains and losses are exchanged at settlement.

Why Use Derivatives?

The primary motivation for using derivatives is the transfer of risk from one party to another. For example, a transport company (long) might use oil forwards to hedge against the risk of rising fuel prices, while an oil producer (short) might use them to hedge against the risk of falling oil prices.

Remember the phrase, “Do in the forward market what you must do in the future,” to help you understand which position to take to hedge a price risk.

Types of Underlying Assets

Derivatives can be based on various underlying assets, such as:

• Commodities (hard and soft)
• Stocks and bonds
• Stock and bond indexes
• Cryptocurrency
• Interest rates, currency exchange rates, and non-financial variables (e.g., weather)

Common Types of Derivatives and Their Uses

Here are some common types of derivatives and their uses:

• Futures Contracts: Used to hedge exposure to stocks and bonds.
• Interest Rate Swaps: Allow participants to hedge interest rate risk on their debt obligations.
• Exchange Rate Forwards: Help global trade participants hedge currency exchange uncertainty on future cash flows.

Derivatives markets often attract investors who want to speculate on the future price of the underlying assets. Derivatives can be particularly suitable for speculation due to their low initial cash requirement and potential for high leverage.

Risk Management vs. Speculation

As we’ve seen, derivatives can serve two main purposes:

1. Risk Management: Participants who are exposed to underlying risks can use derivatives to transfer some of their risk to other parties. This is known as hedging.
2. Speculation: Investors who have no exposure to the underlying risks may use derivatives to gain exposure and speculate on the future price of the underlying assets. Derivatives can offer high leverage, making them attractive for speculation.

Derivative Markets: Exchange-Traded vs. Over-The-Counter

Derivatives can be traded in two main ways: over a central exchange or over-the-counter (OTC) at decentralized locations. Let’s take a closer look at the key differences between these two types of derivative markets:

Exchange-Traded Derivatives

Options, credit derivatives, and futures are examples of exchange-traded derivatives. Participants trade these instruments over a central exchange with the clearinghouse. The clearinghouse acts as the opposite side of each position, effectively being a buyer to every seller and a seller to every buyer. This system allows traders to reverse or reduce their positions easily.

Exchange-traded derivatives have some key features:

• Standardized contracts managed by the clearinghouse
• Margin requirements imposed by the clearinghouse, minimizing counterparty risk
• Usually regulated

Over-The-Counter (OTC) Derivatives

Forwards and swaps are examples of OTC derivatives. Dealers trade these instruments in a market with no central location, entering into custom, negotiated contracts with interested parties. OTC derivatives typically have no margin requirement, which exposes all parties to default risk. OTC markets tend to be less regulated than central exchange markets.

OTC derivatives have some key features:

• Less liquid compared to exchange-traded derivatives
• Pricing is less transparent
• Higher trading costs
• Greater counterparty risk

After the 2008 global financial crisis, regulators worldwide introduced a central clearing mandate, requiring a central counterparty (CCP) to take on the counterparty credit risk for both sides of a contract. This is similar to the role of a clearinghouse. When a dealer enters into a swap contract with a counterparty, they are required to send the information to a Swap Execution Facility (SEF). The CCP replaces the trade with two trades, acting as the counterparty to both of them, thereby reducing counterparty risk. However, the downside of this structure is that counterparty risks are concentrated on a single entity, rather than distributed among financial intermediaries.

That concludes this introductory lesson on derivatives. In our next lesson, we’ll explore the differences between contingent claim derivatives and forward commitment derivatives.