Derivatives

Wendy L. Pirie, Wendy L. Pirie

• Publisher: Wiley
• Year: 2017
• ISBN:
  9781119381761
• Edition: 1
• Topic: Business
• Subtopic: Investimenti e titoli
• Index: Business

The complete guide to derivatives, from the experts at the CFA

Derivatives is the definitive guide to derivatives, derivative markets, and the use of options in risk management. Written by the experts at the CFA Institute, this book provides authoritative reference for students and investment professionals seeking a deeper understanding for more comprehensive portfolio management. General discussion of the types of derivatives and their characteristics gives way to detailed examination of each market and its contracts, including forwards, futures, options, and swaps, followed by a look at credit derivatives markets and their instruments. Included lecture slides help bring this book directly into the classroom, while the companion workbook (sold separately) provides problems and solutions that align with the text and allows students to test their understanding while facilitating deeper internalization of the material.

Derivatives have become essential to effective financial risk management, and create synthetic exposure to asset classes. This book builds a conceptual framework for understanding derivative fundamentals, with systematic coverage and detailed explanations.

• Understand the different types of derivatives and their characteristics
• Delve into the various markets and their associated contracts
• Examine the use of derivatives in portfolio management
• Learn why derivatives are increasingly fundamental to risk management

The CFA Institute is the world's premier association for investment professionals, and the governing body for the CFA, CIPM, and Investment Foundations Programs. Those seeking a deeper understanding of the markets, mechanisms, and use of derivatives will value the level of expertise CFA lends to the discussion, providing a clear, comprehensive resource for students and professionals alike. Whether used alone or in conjunction with the companion workbook, Derivatives offers a complete course in derivatives and their markets.

CHAPTER 1

DERIVATIVE MARKETS AND INSTRUMENTS

Don M. Chance, PhD, CFA

LEARNING OUTCOMES

After completing this chapter, you will be able to do the following:

• 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;

• describe purposes of, and controversies related to, derivative markets;

• explain arbitrage and the role it plays in determining prices and promoting market efficiency.

1. 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.

2. DERIVATIVES: DEFINITIONS AND USES

The most common definition of a derivative reads approximately as follows:

A derivative is a financial instrument that derives its performance from the performance of an underlying asset.

This definition, despite being so widely quoted, can nonetheless be a bit troublesome. For example, it can also describe mutual funds and exchange-traded funds, which would never be viewed as derivatives even though they derive their values from the values of the underlying securities they hold. Perhaps the distinction that best characterizes derivatives is that they usually transform the performance of the underlying asset before paying it out in the derivatives transaction. In contrast, with the exception of expense deductions, mutual funds and exchange-traded funds simply pass through the returns of their underlying securities. This transformation of performance is typically understood or implicit in references to derivatives but rarely makes its way into the formal definition. In keeping with customary industry practice, this characteristic will be retained as an implied, albeit critical, factor distinguishing derivatives from mutual funds and exchange-traded funds and some other straight pass-through instruments. Also, note that the idea that derivatives take their performance from an underlying asset encompasses the fact that derivatives take their value and certain other characteristics from the underlying asset. Derivatives strategies perform in ways that are derived from the underlying and the specific features of derivatives.

Derivatives are similar to insurance in that both allow for the transfer of risk from one party to another. As everyone knows, insurance is a financial contract that provides protection against loss. The party bearing the risk purchases an insurance policy, which transfers the risk to the other party, the insurer, for a specified period of time. The risk itself does not change, but the party bearing it does. Derivatives allow for this same type of transfer of risk. One type of derivative in particular, the put option, when combined with a position exposed to the risk, functions almost exactly like insurance, but all derivatives can be used to protect against loss. Of course, an insurance contract must specify the underlying risk, such as property, health, or life. Likewise, so do derivatives. As noted earlier, derivatives are associated with an underlying asset. As such, the so-called “underlying asset” is often simply referred to as the underlying, whose value is the source of risk.¹ In fact, the underlying need not even be an asset itself. Although common derivatives underlyings are equities, fixed-income securities, currencies, and commodities, other derivatives underlyings include interest rates, credit, energy, weather, and even other derivatives, all of which are not generally thought of as assets. Thus, like insurance, derivatives pay off on the basis of a source of risk, which is often, but not always, the value of an underlying asset. And like insurance, derivatives have a definite life span and expire on a specified date.

Derivatives are created in the form of legal contracts. They involve two parties—the buyer and the seller (sometimes known as the writer)—each of whom agrees to do something for the other, either now or later. The buyer, who purchases the derivative, is referred to as the long or the holder because he owns (holds) the derivative and holds a long position. The seller is referred to as the short because he holds a short position.²

A derivative contract always defines the rights and obligations of each party. These contracts are intended to be, and almost always are, recognized by the legal system as commercial contracts that each party expects to be upheld and supported in the legal system. Nonetheless, disputes sometimes arise, and lawyers, judges, and juries may be required to step in and resolve the matter.

There are two general classes of derivatives. Some provide the ability to lock in a price at which one might buy or sell the underlying. Because they force the two parties to transact in the future at a previously agreed-on price, these instruments are called forward commitments. The various types of forward commitments are called forward contracts, futures contracts, and swaps. Another class of derivatives provides the right but not the obligation to buy or sell the underlying at a pre-determined price. Because the choice of buying or selling versus doing nothing depends on a particular random outcome, these derivatives are called contingent claims. The primary contingent claim is called an option. The types of derivatives will be covered in more detail later in this reading and in considerably more depth later in the curriculum.

The exist...