Refresher Reading
Derivative Benefits, Risks, and Issuer and Investor Uses
2023 Curriculum CFA Program Level I Derivatives
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Earlier lessons described how derivatives expand the set of opportunities available to market participants to create or modify exposure or to hedge the price of an underlying. This learning module describes the benefits and risks of using derivatives and compares their use among issuers and investors.
Learning Outcomes
The member should be able to:
- describe benefits and risks of derivative instruments, and
- compare the use of derivatives among issuers and investors.
Summary
- Derivatives allow market participants to allocate, manage, or trade exposure without exchanging an underlying in the cash market.
- Derivatives also offer greater operational and market efficiency than cash markets and allow users to create exposures unavailable in cash markets.
- Derivative instruments can involve risks, such as a high degree of implicit leverage and less transparency in some cases than cash instruments, as well as basis, liquidity, and counterparty credit risks. Excessive risk taking in the past by market participants through the use of derivatives has contributed to market destabilization and systemic risk.
- Issuers typically use derivative instruments to offset or hedge market-based underlying exposures that affect their assets, liabilities, and earnings.
- Issuers usually seek hedge accounting treatment for derivatives to minimize income statement and cash flow volatility.
- Investors use derivatives to modify investment portfolio cash flows, replicate investment strategy returns in cash markets, and create exposures unavailable to cash market participants.