and equity analysis. Portfolio planning and portfolio management are presented within a context of up-to-date, global coverage of security markets, trading, and market-related concepts and products. The essentials of equity analysis and valuation are explained in detail and profusely illustrated. The book includes coverage of practitioner-important but often neglected topics, such as industry analysis. Throughout, the focus is on the practical application of key concepts with examples drawn from both emerging and developed markets. Each chapter affords the reader many opportunities to self-check his or her understanding of topics.
One of the most prominent texts over the years in the investment management industry has been Maginn and Tuttle’s Managing Investment Portfolios: A Dynamic Process. The third edition updates key concepts from the 1990 second edition. Some of the more experienced members of our community own the prior two editions and will add the third edition to their libraries. Not only does this seminal work take the concepts from the other readings and put them in a portfolio context, but it also updates the concepts of alternative investments, performance presentation standards, portfolio execution, and, very importantly, individual investor portfolio management. Focusing attention away from institutional portfolios and toward the individual investor makes this edition an important and timely work.
Quantitative Investment Analysis focuses on some key tools that are needed by today’s professional investor. In addition to classic time value of money, discounted cash flow applications, and probability material, there are two aspects that can be of value over traditional thinking.
The New Wealth Management: The Financial Advisor’s Guide to Managing and Investing Client Assets is an updated version of Harold Evensky’s mainstay reference guide for wealth managers. Harold Evensky, Stephen Horan, and Thomas Robinson have updated the core text of the 1997 first edition and added an abundance of new material to fully reflect today’s investment challenges. The text provides authoritative coverage across the full spectrum of wealth management and serves as a comprehensive guide for financial advisors. The book expertly blends investment theory and real-world applications and is written in the same thorough but highly accessible style as the first edition. The first involves the chapters dealing with correlation and regression that ultimately figure into the formation of hypotheses for purposes of testing. This gets to a critical skill that challenges many professionals: the ability to distinguish useful information from the overwhelming quantity of available data. Second, the final chapter of Quantitative Investment Analysis covers portfolio concepts and takes the reader beyond the traditional capital asset pricing model (CAPM) type of tools and into the more practical world of multifactor models and arbitrage pricing theory.
All books in the CFA Institute Investment Series are available through all major booksellers. And, all titles are available on the Wiley Custom Select platform at http://customselect.wiley.com/ where individual chapters for all the books may be mixed and matched to create custom textbooks for the classroom.
CHAPTER 1
DERIVATIVE MARKETS AND INSTRUMENTS
LEARNING OUTCOMES
After completing this chapter, you will be able to do the following:
• define a derivative and distinguish between exchange-traded and over-the-counter derivatives;
• contrast forward commitments with contingent claims;
• define forward contracts, futures contracts, options (calls and puts), swaps, and credit derivatives and compare their basic characteristics;
• describe purposes of, and controversies related to, derivative markets;
• explain arbitrage and the role it plays in determining prices and promoting market efficiency.
1. INTRODUCTION
Equity, fixed-income, currency, and commodity markets are facilities for trading the basic assets of an economy. Equity and fixed-income securities are claims on the assets of a company. Currencies are the monetary units issued by a government or central bank. Commodities are natural resources, such as oil or gold. These underlying assets are said to trade in cash markets or spot markets and their prices are sometimes referred to as cash prices or spot prices, though we usually just refer to them as stock prices, bond prices, exchange rates, and commodity prices. These markets exist around the world and receive much attention in the financial and mainstream media. Hence, they are relatively familiar not only to financial experts but also to the general population.
Somewhat less familiar are the markets for derivatives, which are financial instruments that derive their values from the performance of these basic assets. This reading is an overview of derivatives. Subsequent readings will explore many aspects of derivatives and their uses in depth. Among the questions that this first reading will address are the following:
• What are the defining characteristics of derivatives?
• What purposes do derivatives serve for financial market participants?
• What is the distinction between a forward commitment and a contingent claim?
• What are forward and futures contracts? In what ways are they alike and in what ways are they different?
• What are swaps?
• What are call and put options and how do they differ from forwards, futures, and swaps?
• What are credit derivatives and what are the various types of credit derivatives?
• What are the benefits of derivatives?
• What are some criticisms of derivatives and to what extent are they well founded?
• What is arbitrage and what role does it play in a well-functioning financial market?
This reading is organized as follows. Section 2 explores the definition and uses of derivatives and establishes some basic terminology. Section 3 describes derivatives markets. Section 4 categorizes and explains types of derivatives. Sections 5 and 6 discuss the benefits and criticisms of derivatives, respectively. Section 7 introduces the basic principles of derivative pricing and the concept of arbitrage. Section 8 provides a summary.
2. DERIVATIVES: DEFINITIONS AND USES
The most common definition of a derivative reads approximately as follows:
A derivative is a financial instrument that derives its performance from the performance of an underlying asset.
This definition, despite being so widely quoted, can nonetheless be a bit troublesome. For example, it can also describe mutual funds and exchange-traded funds, which would never be viewed as derivatives even though they derive their values from the values of the underlying securities they hold. Perhaps the distinction that best characterizes derivatives is that they usually transform the performance of the underlying asset before paying it out in the derivatives transaction. In contrast, with the exception of expense deductions, mutual funds and exchange-traded funds simply pass through the returns of their underlying securities. This transformation of performance is typically understood or implicit in references to derivatives but rarely makes its way into the formal definition. In keeping with
