This lesson provides a detailed examination of the derivative instruments used in risk management and the distinction between hedging and speculation.

5.1. Key Derivative Types

Derivatives are financial contracts whose value is derived from an underlying asset, index, or reference rate. They are used for hedging risk, for speculation, and for arbitrage. The ACT and CTP curricula require a thorough understanding of these instruments . Key types include:

• Forwards: OTC contracts to buy or sell an asset at a set price on a future date.

• Futures: Standardised, exchange-traded forward contracts .

• Swaps: OTC contracts to exchange cash flows, often used to swap a fixed rate for a floating rate .

• Options: Contracts giving the holder the right, but not the obligation, to buy (call) or sell (put) an asset at a specified price .

5.2. Forward vs. Futures

Key differences include:

• Standardisation: Futures are standardised; forwards are customisable.

• Trading Venue: Futures are exchange-traded; forwards are OTC.

• Settlement: Futures are marked-to-market daily; forwards are settled at maturity.

5.3. Hedging vs. Speculation

A fundamental principle of treasury risk management is the distinction between hedging and speculation .

• Hedging: Using derivatives to reduce or eliminate an existing financial risk. This is the primary purpose of treasury operations .

• Speculation: Using derivatives to take on risk in the hope of making a profit. This is not a core treasury function.

5.4. Options Fundamentals

Options give the holder the right to buy (call) or sell (put) an asset at a specified price (the strike price). Key terms include:

• Premium: The price paid for the option.

• Maximum Loss: For a buyer of a call option, the maximum loss is the premium paid .

• Break-Even Point: The all-in break-even point for a call option is the strike price plus the premium paid .