Reading 48: Derivative Markets and Instruments

Learning Outcome Statements

• Covered
• 48a, 48b, 48c, 48d, 48e, 48f

• Not Covered
• None
 Derivatives
A derivative is a financial contract or instrument that derives its value from the value of
something else.

The underlying on which a derivative is based can be an asset (e.g., stocks and bonds), an index
(e.g., S&P 500), or something else (e.g., interest rates).

Exchange-traded derivatives are traded on specialized derivatives exchanges or other exchanges.

These contracts are standardized and backed by a clearinghouse.

Over-the-counter derivatives do not trade in a centralized market; instead, their market is created
by dealers.
These are custom instruments where the parties involved in the transaction determine the terms
and conditions of the contract.
 Exchange‐Traded Derivatives Markets
• Standardization facilitates the creation of a more liquid market for derivatives.
However, it comes at the cost of flexibility.

• Market makers and speculators play an important role in these markets.

• The exchange is responsible for clearing and settlement through its clearinghouse.

• Exchange markets also have transparency (i.e., information regarding all

transactions is disclosed to regulatory bodies).
 Over‐the‐Counter (OTC) Derivatives Markets
• OTC derivatives trade in an informal market.

• OTC derivatives are customized instruments.

• Note that there is a tendency to think that the OTC market is less liquid than the
exchange market. This is not necessarily true.

• OTC derivatives markets are less regulated than exchange‐traded derivatives

markets.

• OTC markets offer more privacy and flexibility than exchange markets.
 Forward Commitment
A forward commitment is a legal obligation to engage in a certain transaction in the spot market
at a future date at terms agreed upon today.

Forwards: These are customized and private contracts between two parties whereby one party has
the obligation to buy an asset, and the counterparty has the obligation to sell the asset, at a
specific price on a specific date in the future.

Futures: These are standardized derivative contracts whereby one party, the buyer, will purchase
an underlying asset from the other party, the seller, at a later date at a price agreed upon at
contract initiation.

Swaps: These contracts give rise to obligations for both parties to exchange a series of cash flows
in the future.
 Practice Question
Which of the following is most likely correct about forward contracts?

A. They are customized and private contracts.

B. They are standardized derivative contracts.
C. There is daily settlement of gains and losses.
 Contingent Claim
A contingent claim is a derivative in which the outcome or payoff is determined by the outcome
or payoff of an underlying asset, conditional on some event occurring.

Options are derivative instruments that give their holders the choice (not the obligation) to buy or
sell the underlying from or to the seller (writer) of the option.

A credit derivative is a contract that transfers credit risk from one party (the credit protection
buyer) to another party (the credit protection seller), where the latter protects the former against a
specific credit loss.

An asset‐backed security (ABS) is a derivative in which a portfolio of debt instruments is pooled

and claims are issued on the portfolio in the form of tranches, which have different priorities of
claims on the payments that come in from the pool of debt securities.
 Credit Derivative
A credit default swap (CDS) is a bilateral contract between two parties that transfers the credit
risk embedded in a reference obligation from one party to another.

The reference obligation is the fixed‐income security on which the protection is written (or whose
credit risk is transferred).

The protection buyer makes a series of periodic payments (think of them as periodic insurance
premium payments) to the protection seller during the term of the CDS.

The protection seller earns the CDS spread over the term of the CDS in return for assuming the
credit risk in the reference obligation.
 Purposes and Benefits of Derivatives
• Risk allocation, transfer, and management

• Information discovery

• Operational advantages

• Market efficiency
 Risk Allocation, Transfer, and Management
• Derivatives allow investors to hedge away risks without trading the underlying
itself.

• They improve risk allocation within markets, as parties who do not want exposure
to a particular risk can transfer it to those who do.
 Information Discovery
• Certain forms of derivative contracts provide an indication of the direction of the
underlying.

• Since derivative transactions involve less capital, information can sometimes be

reflected in derivatives prices more quickly than in spot prices.

• Certain derivatives can be used to implement strategies that cannot be

implemented with the underlying alone.

• Option market prices can be used to infer implied volatility, which can be used to
measure the risk of the underlying.
 Operational Advantages
• Derivatives entail lower transaction costs than comparable spot market
transactions.

• Derivatives markets are typically more liquid than the underlying spot markets.

• Derivatives offer an easy way to take a short position on the underlying.

• Derivatives allow users to engage in highly leveraged transactions.

 Market Efficiency
• When asset prices deviate from the fundamental values, derivatives markets offer a
less costly way of taking advantage of the mispricing.

• The ability to hedge various risks through derivatives increases the willingness of
market participants to trade and improves liquidity in the market.
 Criticisms and Misuses of Derivatives
Destabilization and systematic risk
The very benefits of derivatives result in an excessive amount of speculative trading that
brings instability to the market.

Speculation and gambling

Speculators take on risk and are compared to gamblers. However, gambling benefits
only a limited number of participants, with no benefit to society as a whole.

Complexity
Lack of understanding on the part of users can result in significant losses.
 Arbitrage
Arbitrage plays an important role in the study of derivatives.

It is an important feature of efficient markets because it helps:

• Determine prices
• Improve market efficiency
 Practice Question
Which of the following is least likely to be considered a benefit of derivatives?

A. Price discovery
B. Risk management
C. Complexity
Practice Questions with Solutions
 Practice Question
Which of the following is most likely correct about forward contracts?

A. They are customized and private contracts.

B. They are standardized derivative contracts.
C. There is daily settlement of gains and losses.

Answer: A
Forwards are customized and private contracts between two parties.
Futures are standardized derivative contracts.
For futures contracts, there is daily settlement of gains and losses, and the futures
exchange (through its clearinghouse) provides a credit guarantee.
 Practice Question
Which of the following is least likely to be considered a benefit of derivatives?

A. Price discovery
B. Risk management
C. Complexity

Answer: C
Lack of understanding on the part of users can result in significant losses.
Futures, forwards, and swaps offer market participants important information about
the price of the underlying asset.
Derivatives are used to hedge exposure to asset prices or interest rates.