Learning Objectives:

  • Define derivatives and understand their uses: hedging, speculation, and arbitrage 

  • Distinguish between firm commitments (forwards, futures, swaps) and contingent claims (options) 

  • Determine the value at expiration and profit from positions in forwards, futures, and options 

6.1 Derivatives Fundamentals

Derivatives are financial contracts whose value is derived from an underlying asset, index, or reference rate. The CFA Institute defines a derivative as “a financial instrument that derives its performance from an underlying asset, index, or other financial variable” . The University of York module covers “Derivative securities” and how they “can be used to mitigate risk” . The University of Coimbra syllabus includes “Financial derivatives” as a core topic . The University of Warsaw syllabus includes “Derivative instruments and markets” .

Key Functions of Derivatives:

  • Hedging: Reducing or eliminating risk .

  • Speculation: Taking on risk for potential gain.

  • Arbitrage: Exploiting price differences.

  • Efficient Portfolio Adjustment: Adjusting portfolio exposures without trading underlying assets.

6.2 Forward Contracts

The CFA Institute materials define forwards as “a flexible over-the-counter (OTC) derivative instrument” . The Cambridge University Press chapter on derivatives identifies forwards as one of the four types of derivatives that stand out .

Key Characteristics:

  • OTC Contracts: Negotiated directly between counterparties, allowing customisation of terms .

  • Firm Commitment: Both parties are obligated to transact at the agreed price on the settlement date .

  • Physical or Cash Settlement: Can be settled by physical delivery of the underlying or by cash settlement .

  • Counterparty Risk: Default risk exists because contracts are not exchange-traded .

6.3 Futures Contracts

The CFA Institute materials state that “futures are standardized and traded on an exchange with a daily settlement of contract gains and losses” . The Cambridge University Press chapter identifies futures contracts as one of the four types of derivatives .

Key Characteristics:

  • Exchange-Traded: Standardised contracts traded on organised exchanges, ensuring liquidity .

  • Daily Settlement (Mark-to-Market): Gains and losses are settled daily, reducing credit risk .

  • Margin Requirements: Initial and variation margin are required to cover potential losses .

  • Central Clearing: Exchanges guarantee contract performance through clearinghouses .

  • Liquidity: Highly liquid markets for standard contracts .

6.4 Options

The CFA Institute materials define options as “contingent claims in which one of the counterparties determines whether and when a trade will settle. The option buyer pays a premium to the seller for the right to transact the underlying in the future at a pre-agreed exercise price” .

Key Option Types:

  • Call Options: The right to buy an asset at a specified price (strike/exercise price).

  • Put Options: The right to sell an asset at a specified price .

Key Option Terms:

  • Premium: The price paid for the option .

  • Strike Price (Exercise Price): The price at which the option can be exercised .

  • Expiration: The date on which the option expires .

  • Intrinsic Value: The value of an option if exercised immediately.

  • Time Value: The value attributed to the time remaining until expiration.

Non-Linear Payoff: “Option contract payoff and profit profiles are non-linear as the underlying price changes, as opposed to firm commitments, such as forwards, futures, and swaps, which are linear in underlying price changes” .

6.5 Swaps

The CFA Institute materials define swap contracts as “a firm commitment to exchange a series of cash flows in the future. Interest rate swaps are the most common type and involve the exchange of fixed interest payments for floating interest payments” .

Key Features of Interest Rate Swaps:

  • OTC Contracts: Customised contracts negotiated between counterparties .

  • Interest Rate Exposure: Used to manage interest rate risk by transforming fixed-rate exposure to floating-rate exposure or vice versa .

  • Large Market: The NYU Stern materials note that interest rate swaps are a “major component of the large and growing market for interest-rate derivatives” .

  • Counterparty Risk: Credit risk depends on the safety of the counterparty, managed through high-quality counterparties and posting of collateral .

Other Types of Swaps:

  • Currency Swaps: Exchanging principal and interest in different currencies.

  • Credit Default Swaps (CDS): A contract where the buyer makes periodic payments to the seller in exchange for protection against default on a reference asset

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