Refresher Reading

Derivative Markets and Instruments

2022 Curriculum CFA Program Level I Derivatives

Introduction

Equity, fixed-income, currency, and commodity markets are facilities for trading the basic assets of an economy. Equity and fixed-income securities are claims on the assets of a company. Currencies are the monetary units issued by a government or central bank. Commodities are natural resources, such as oil or gold. These underlying assets are said to trade in cash markets or spot markets and their prices are sometimes referred to as cash prices or spot prices, though we usually just refer to them as stock prices, bond prices, exchange rates, and commodity prices. These markets exist around the world and receive much attention in the financial and mainstream media. Hence, they are relatively familiar not only to financial experts but also to the general population.

Somewhat less familiar are the markets for derivatives, which are financial instruments that derive their values from the performance of these basic assets. This reading is an overview of derivatives. Subsequent readings will explore many aspects of derivatives and their uses in depth. Among the questions that this first reading will address are the following:

What are the defining characteristics of derivatives?
What purposes do derivatives serve for financial market participants?
What is the distinction between a forward commitment and a contingent claim?
What are forward and futures contracts? In what ways are they alike and in what ways are they different?
What are swaps?
What are call and put options and how do they differ from forwards, futures, and swaps?
What are credit derivatives and what are the various types of credit derivatives?
What are the benefits of derivatives?
What are some criticisms of derivatives and to what extent are they well founded?
What is arbitrage and what role does it play in a well-functioning financial market?

This reading is organized as follows. Section 2 explores the definition and uses of derivatives and establishes some basic terminology. Section 3 describes derivatives markets. Section 4 categorizes and explains types of derivatives. Sections 5 and 6 discuss the benefits and criticisms of derivatives, respectively. Section 7 introduces the basic principles of derivative pricing and the concept of arbitrage. Section 8 provides a summary.

Learning Outcomes

The member should be able to:

define a derivative and distinguish between exchange-traded and over-the-counter derivatives;
contrast forward commitments with contingent claims;
define forward contracts, futures contracts, options (calls and puts), swaps, and credit derivatives and compare their basic characteristics;
determine the value at expiration and profit from a long or a short position in a call or put option;
describe purposes of, and controversies related to, derivative markets;
explain arbitrage and the role it plays in determining prices and promoting market efficiency.

Summary

This first reading on derivatives introduces you to the basic characteristics of derivatives, including the following points:

A derivative is a financial instrument that derives its performance from the performance of an underlying asset.
The underlying asset, called the underlying, trades in the cash or spot markets and its price is called the cash or spot price.
Derivatives consist of two general classes: forward commitments and contingent claims.
Derivatives can be created as standardized instruments on derivatives exchanges or as customized instruments in the over-the-counter market.
Exchange-traded derivatives are standardized, highly regulated, and transparent transactions that are guaranteed against default through the clearinghouse of the derivatives exchange.
Over-the-counter derivatives are customized, flexible, and more private and less regulated than exchange-traded derivatives, but are subject to a greater risk of default.
A forward contract is an over-the-counter derivative contract in which two parties agree that one party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date and at a fixed price they agree upon when the contract is signed.
A futures contract is similar to a forward contract but is a standardized derivative contract created and traded on a futures exchange. In the contract, two parties agree that one party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date and at a price agreed on by the two parties when the contract is initiated. In addition, there is a daily settling of gains and losses and a credit guarantee by the futures exchange through its clearinghouse.
A swap is an over-the-counter derivative contract in which two parties agree to exchange a series of cash flows whereby one party pays a variable series that will be determined by an underlying asset or rate and the other party pays either a variable series determined by a different underlying asset or rate or a fixed series.
An option is a derivative contract in which one party, the buyer, pays a sum of money to the other party, the seller or writer, and receives the right to either buy or sell an underlying asset at a fixed price either on a specific expiration date or at any time prior to the expiration date.
A call is an option that provides the right to buy the underlying.
A put is an option that provides the right to sell the underlying.
Credit derivatives are a class of derivative contracts between two parties, the credit protection buyer and the credit protection seller, in which the latter provides protection to the former against a specific credit loss.
A credit default swap is the most widely used credit derivative. It is a derivative contract between two parties, a credit protection buyer and a credit protection seller, in which the buyer makes a series of payments to the seller and receives a promise of compensation for credit losses resulting from the default of a third party.
An asset-backed security is a derivative contract in which a portfolio of debt instruments is assembled and claims are issued on the portfolio in the form of tranches, which have different priorities of claims on the payments made by the debt securities such that prepayments or credit losses are allocated to the most-junior tranches first and the most-senior tranches last.
Derivatives can be combined with other derivatives or underlying assets to form hybrids.
Derivatives are issued on equities, fixed-income securities, interest rates, currencies, commodities, credit, and a variety of such diverse underlyings as weather, electricity, and disaster claims.
Derivatives facilitate the transfer of risk, enable the creation of strategies and payoffs not otherwise possible with spot assets, provide information about the spot market, offer lower transaction costs, reduce the amount of capital required, are easier than the underlyings to go short, and improve the efficiency of spot markets.
Derivatives are sometimes criticized for being a form of legalized gambling and for leading to destabilizing speculation, although these points can generally be refuted.
Derivatives are typically priced by forming a hedge involving the underlying asset and a derivative such that the combination must pay the risk-free rate and do so for only one derivative price.
Derivatives pricing relies heavily on the principle of storage, meaning the ability to hold or store the underlying asset. Storage can incur costs but can also generate cash, such as dividends and interest.
Arbitrage is the condition that two equivalent assets or derivatives or combinations of assets and derivatives sell for different prices, leading to an opportunity to buy at the low price and sell at the high price, thereby earning a risk-free profit without committing any capital.
The combined actions of arbitrageurs bring about a convergence of prices. Hence, arbitrage leads to the law of one price: Transactions that produce equivalent results must sell for equivalent prices.