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

Test your understanding of the primary purposes, expected outcomes, limitations, and validity factors of the discussed methodology. This quiz encourages critical thinking about research processes and their interpretations.