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The material in this blog post is useful to the candidates preparing for: Both Level I and Level II of CFA Exams

Over the next couple of days, I will be discussing about option strategies that appear in both level I and level II. Therefore, a good start would be to introduce the readers to the derivative markets, compare between the different derivative products and describe their special characteristics.

What are derivatives?

Derivatives are financial products that derive their value from the underlying asset. The underlying asset could be a stock, bond, commodity, or could be even based on weather.

What is the size of the derivatives market?

The derivatives market is huge – much bigger than stock market when measured in terms of underlying assets. Derivatives markets have come under a great deal of criticism because of their role in the credit crisis that started in 2007. Derivative products were created from portfolios of risky mortgages in the United States using a procedure known as securitization. Many of the products that were created became worthless when house prices declined. As a result of the crisis, derivative markets are now much more regulated.

What are the types of derivative markets?

In general, there are two major types of markets of derivatives: over-the-counter and exchange-traded markets. Traditionally, derivatives exchanges have used when is known as open outcry system that involves physical meeting. Electronic trading has led to a growth in algorithmic trading in which computer programs initiate trades instead of humans. The over-the-counter market is important alternative to exchanges and when measured in terms of total volume of trading, it has become much larger than exchange-traded market. A key advantage of the over-the-counter market is that terms don’t have to be specified by exchange and participants are free to negotiate as they wish; however, the elimination of exchange introduces credit risk to the contract.

What are the different types of instruments? 

Generally, they fall under two categories:

• Forward commitments: Represents an agreement between two parties in which one party, the buyer, agrees (is obligated) to buy/sell from/for the other party, the seller/writer, the underlying asset in the future at predetermined price.

• Examples include: Futures, forwards, swaps

Instruments – Forwards

Forward contracts are agreements to buy/sell an asset at a future date at a price agreed on today. No money changes hands at the start of either transaction. Forward contracts are far less visible segment of the financial markets.

Instruments – Futures

Future contracts are agreements to buy/sell an asset at a future date at a price agreed on today. No money changes hands at the start of either transaction. However, future contracts are more standardized and have less credit risk. Price discovery and risk management are primary advantages of futures. With an open, standardized, regulated market, futures are liquid.

Both forwards and futures serve a similar purpose: They provide a mean in which a party can commit to the future purchase or sale of an asset at an agreed-upon price, without the necessity of paying any cash until the asset is actually purchased or sold. Due to margin posting, futures, however, provide interim cash flows that can lead to imperfections in a hedge transaction designed not to hedge interim events but to hedge a specific event at a target horizon date.  In futures contract, margin is commonly used to describe the amount of money that must be deposited into account by a party opening up a new position. The exact details of margin posting and futures markets will be explained in a later post.

Instruments – Swap

A swap can be viewed as a series of forward contracts. Swaps are much more widely used than forward contracts, suggesting that parties that have specific risk management needs typically require the equivalent of a series of forward contracts. The tremendous popularity of swaps results largely from the popularity of interest rate swaps. For several reasons, these instruments have been embraced by corporations as tools for managing interest rate risk. For example, IRS is considered to be a simple instrument and doesn’t involve complex calculations. Also, interest rate swaps can be easily viewed as pair of loans. Many corporations are restricted in their use of options and futures, buy they can usually justify swaps as nothing more than variations of loans. Also, swaps provide a mechanism for managing the risks associated with a series of payments. The exact details of margin posting and futures markets will be explained in a later post.

Instruments – Options

An option gives the holder the right, but not the obligation, to buy or sell a given quantity of an asset on (or perhaps before) a given date, at prices agreed upon today.

• Call options gives the holder the right, but not the obligation, to buy a given quantity of some asset at some time in the future, at prices agreed upon today. When exercising a call option, you “call in” the asset.
• Put options gives the holder the right, but not the obligation, to sell a given quantity of an asset at some time in the future, at prices agreed upon today. When exercising a put, you “put” the asset to someone.

Advantages that options offer over other derivatives:

1. They offer the feature that, if one is willing to pay cash up front, one can limit the loss in a given direction. In other words, options have unidirectional payoffs
2. Options also offer excellent devices for managing the risk of various exposures
3. Options provide volatility discovery (implied volatility)
4. Options can be customized or standardized (i.e. over-the-counter and exchanged-listed)

What are the differences between forwards and futures?

The next table summarizes the main differences between forwards and futures: