Methodology Analysis Quiz

Derivative Benefits, Risks, and Issuer and Investor Uses

• Derivatives allow market participants to allocate, manage, or trade exposure without exchanging an underlying in the cash market
• Derivatives offer greater operational and market efficiency than cash markets
• Derivatives allow to create exposures unavailable in cash markets
• Derivatives involve risks such as high degree of implicit leverage, less transparency, basis, liquidity and counterparty credit risks
• Excessive risk-taking through derivatives may cause market destabilization and systemic risk
• Issuers use derivatives to offset or hedge market-based underlying exposures impacting assets, liabilities, and earnings
• Issuers usually seek hedge accounting treatment to minimize income statement and cash flow volatility
• Investors use derivatives to modify investment portfolio cashflows, replicate investment strategy returns, or create exposures unavailable in cash markets.

Derivative Markets

• OTC markets involve contracts between derivatives end users and dealers (market makers)
• OTC markets can be formal organizations (e.g., NASDAQ) or informal networks
• In OTC markets, dealers often enter into offsetting bilateral transactions to transfer risk to other parties
• Terms of OTC contracts are often customized to match a desired risk exposure profile
• Exchange-traded derivatives include futures, options, and other financial contracts available on exchanges
• ETD contracts are standardized; facilitate more liquid and transparent markets
• Terms and conditions (e.g., contract size, type, quality of underlying, delivery date) are set by the exchange.

Derivative Underlyings

• Equity derivatives usually reference an individual stock, a group of stocks, or a stock index
• Bond and related derivatives include options, forwards, futures, and swaps
• Interest rate is not an asset, but a fixed-income underlying used in many interest rate derivatives
• Market reference rate (MRR) is a most common interest rate underlying
• Market participants use derivatives to hedge foreign exchange risk
• Soft commodities are agricultural products (e.g., cattle, corn)
• Hard commodities are natural resources (e.g., crude oil, metals)
• Credit derivatives are based on the default risk of a single issuer or a group of issuers
• Other derivative underlyings include weather, cryptocurrencies, and longevity

Forward Commitment and Contingent Claim Features and Instruments

• A derivative is a financial instrument that derives its value from an underlying asset or index
• A firm commitment is an obligation to exchange a predetermined amount that is agreed to be exchanged at settlement
• A contingent claim is where one of the counterparties determines whether or when the trade will settle
• Derivatives contract can be customized to match a desired exposure profile
• A forward contract is an OTC derivative where one party agrees to buy and another to sell an asset at a future date at a fixed price
• A futures contract is standardized and traded on an exchange with daily gains/losses settled through a margin account
• A swap contract is a firm commitment to exchange a series of future cash flows

Pricing and Valuation of Forward Contracts

• A forward contract is priced to eliminate arbitrage opportunities.
• The forward price is equal to the current spot price plus or minus all costs and benefits over the life of the contract.
• The forward contract is priced at either a premium or a discount relative to the spot price depending on the costs and benefits
• The costs or benefits associated with holding the underlying asset are considered as net costs or benefits.

Pricing and Valuation of Futures Contracts

• Futures contracts are standardized contracts traded on exchanges.
• Futures prices are determined at inception and reset daily to reflect changes in the underlying's price
• Gains and losses are calculated each day, settled to zero, and variations are settled in a margin account
• Futures contracts have greater liquidity versus comparable forward contracts

MTM Valuation: Forwards versus Futures

• Forward contracts have a fixed price until maturity
• Futures contracts are reset daily to zero according to the prevailing market price
• MTM gain or loss is settled daily for futures and varies between the market and contract prices
• Both contracts are approximately equivalent when the contract matures

Pricing and Valuation of Interest Rates and Other Swaps

• A swap contract is a series of forward contracts
• The value of a swap is the present value of all future cash flows discounted to the present time period
• Swaps are typically used to manage interest-rate exposure
• If expected forward rates rise, the fixed-rate payer's (receiver's) MTM value increases/decreases due to floating rates
• Swap contracts have a zero value at inception