Derivative Benefits and Risks | CFA Level I Derivatives

Benefits of Derivatives

Ever wondered why some people prefer trading in the derivatives market over the cash market? Here are a few key benefits:

• Risk exposure management: Derivatives allow for better control over one’s exposure to price risk. For example, a portfolio manager can decrease exposure to US stocks by taking a position in S&P500 futures at lower transaction costs and less price impact on the underlying.
• Creating unique risk exposures: Derivatives enable investors or speculators to create risk exposures not available in cash markets. For instance, a long call option allows an investor to acquire unlimited upside potential while limiting downside risk.
• Information discovery: Derivatives help reveal information about the direction of cash markets, particularly in low liquidity markets or when the underlying market is closed.
• Market efficiency: The operational efficiency of derivatives markets leads to greater market efficiency, thanks to factors like low transaction costs, increased liquidity and leverage, and ease of short sales.
• Operational advantages: Derivatives offer several operational benefits over cash markets, such as easier short positions, lower transaction costs, and lesser cash requirements.

Risks of Derivatives

Now, let’s switch gears and look at the potential risks that come with trading in derivatives:

• Leverage risk: The implicit leverage in derivatives means that investors can take large positions with very little cash, leading to higher leverage risk and potentially amplified losses during adverse market moves.
• Structured note risks: Structured notes with embedded derivatives can be sold as low-risk securities to unsuspecting retail investors, who may not fully understand the highly leveraged positions they’re taking on.
• Basis risk: Basis risk arises when the hedged position doesn’t perfectly align with the actual risk of the underlying asset, resulting in changes in portfolio value despite the hedge.
• Liquidity risk: This type of risk in derivatives occurs when cash flows from a hedge don’t match the cash flows of investor positions, possibly leading to difficulty in raising liquidity to meet margin calls or prematurely closed positions.
• Systemic risk: Excessive speculation using derivative instruments can lead to widespread impact on financial markets and institutions. Market regulators work to reduce systemic risk through regulation.
• Counterparty credit risk: This risk involves the opposite party not meeting their contractual obligations in a derivative contract, potentially affecting both buyers and sellers of forwards or swaps.

Issuer Uses of Derivatives

Issuers, or corporate users of derivative instruments, are non-financial corporations that may face risks associated with changes in asset or liability values or cash flow volatility. These changes can stem from fluctuations in underlying security prices, market values, exchange rates, or interest rates. To hedge against such risks, issuers may take positions in derivatives.

Hedge accounting is an important concept to understand. It allows firms to recognize gains and losses of qualifying derivative hedges to offset changes in the values of assets, liabilities, or cash flows being hedged.

There are three main types of hedge accounting:

1. Fair value hedge: This type of hedge is used to smoothen the fluctuation in value of a firm’s assets or liabilities. It involves taking positions in derivatives that have an inverse relationship with the value of the asset or liability being hedged.
2. Net investment hedge: This hedge is used to mitigate the risk of fluctuating market prices for the subsidiary’s shares. The parent company may sell forwards in the subsidiary’s shares to hedge against changes in the reported value of the subsidiary.
3. Cash flow hedge: Used to hedge against exchange rate risk, this type of hedge involves using currency forwards or swaps to potentially smooth earnings in a volatile exchange rate situation.

Investor Uses of Derivatives

Investors primarily use derivatives to temporarily hedge against or modify certain portfolio risks. Here are some examples:

• Equity portfolio management: Managers can modify their portfolio’s market risk exposure at a low cost by buying or selling equity index futures, or by buying put options on an equity index to decrease downside risk while preserving upside potential.
• Fixed income portfolio management: Managers can increase the duration of their bond portfolio by entering an interest rate swap as the floating-rate payer and fixed-rate receiver, effectively converting the fixed-rate liability to a floating-rate liability.
• Speculation: Some investors may use derivatives to gain exposure to the risk of an underlying asset at a low cost, such as buying crude oil forwards to gain long exposure to the price of crude oil with little or no initial funds required.