They take their values from the value of something else.
Solution to 1: C is correct. Mutual funds and government bonds are not derivatives. A government bond is a fundamental asset on which derivatives might be created, but it is not a derivative itself. A mutual fund can technically meet the definition of a derivative, but as noted in the reading, derivatives transform the value of a payoff of an underlying asset. Mutual funds merely pass those payoffs through to their holders.
Solution to 2: B is correct. All derivatives have an underlying and must have a buyer and a seller. More importantly, derivatives have high degrees of leverage, not low degrees of leverage.
Solution to 3: A is correct. Derivatives are used to practice risk management and they take (derive) their values from the value of something else, the underlying. They are not created in the spot market, which is where the underlying trades.
Note also that risk management is a dynamic and ongoing process, reflecting the fact that the risk assumed can be difficult to measure and is constantly changing. As noted, derivatives are tools, indeed the tools that make it easier to manage risk. Although one can trade stocks and bonds (the underlyings) to adjust the level of risk, it is almost always more effective to trade derivatives.
Risk management is addressed more directly elsewhere in the CFA curriculum, but the study of derivatives necessarily entails the concept of risk management. In an explanation of derivatives, the focus is usually on the instruments and it is easy to forget the overriding objective of managing risk. Unfortunately, that would be like a carpenter obsessed with his hammer and nails, forgetting that he is building a piece of furniture. It is important to always try to keep an eye on the objective of managing risk.
3. THE STRUCTURE OF DERIVATIVE MARKETS
Having an understanding of equity, fixed-income, and currency markets is extremely beneficial – indeed, quite necessary – in understanding derivatives. One could hardly consider the wisdom of using derivatives on a share of stock if one did not understand the equity markets reasonably well. As you likely know, equities trade on organized exchanges as well as in over-the-counter (OTC) markets. These exchange-traded equity markets – such as the Deutsche Börse, the Tokyo Stock Exchange, and the New York Stock Exchange and its Eurex affiliate – are formal organizational structures that bring buyers and sellers together through market makers, or dealers, to facilitate transactions. Exchanges have formal rule structures and are required to comply with all securities laws.
OTC securities markets operate in much the same manner, with similar rules, regulations, and organizational structures. At one time, the major difference between OTC and exchange markets for securities was that the latter brought buyers and sellers together in a physical location, whereas the former facilitated trading strictly in an electronic manner. Today, these distinctions are blurred because many organized securities exchanges have gone completely to electronic systems. Moreover, OTC securities markets can be formally organized structures, such as NASDAQ, or can merely refer to informal networks of parties who buy and sell with each other, such as the corporate and government bond markets in the United States.
The derivatives world also comprises organized exchanges and OTC markets. Although the derivatives world is also moving toward less distinction between these markets, there are clear differences that are important to understand.
3.1. Exchange-Traded Derivatives Markets
Derivative instruments are created and traded either on an exchange or on the OTC market. Exchange-traded derivatives are standardized, whereas OTC derivatives are customized. To standardize a derivative contract means that its terms and conditions are precisely specified by the exchange and there is very limited ability to alter those terms. For example, an exchange might offer trading in certain types of derivatives that expire only on the third Friday of March, June, September, and December. If a party wanted the derivative to expire on any other day, it would not be able to trade such a derivative on that exchange, nor would it be able to persuade the exchange to create it, at least not in the short run. If a party wanted a derivative on a particular entity, such as a specific stock, that party could trade it on that exchange only if the exchange had specified that such a derivative could trade. Even the magnitudes of the contracts are specified. If a party wanted a derivative to cover €150,000 and the exchange specified that contracts could trade only in increments of €100,000, the party could do nothing about it if it wanted to trade that derivative on that exchange.
This standardization of contract terms facilitates the creation of a more liquid market for derivatives. If all market participants know that derivatives on the euro trade in 100,000-unit lots and that they all expire only on certain days, the market functions more effectively than it would if there were derivatives with many different unit sizes and expiration days competing in the same market at the same time. This standardization makes it easier to provide liquidity. Through designated market makers, derivatives exchanges guarantee that derivatives can be bought and sold.3
The cornerstones of the exchange-traded derivatives market are the market makers (or dealers) and the speculators, both of whom typically own memberships on the exchange.4 The market makers stand ready to buy at one price and sell at a higher price. With standardization of terms and an active market, market makers are often able to buy and sell almost simultaneously at different prices, locking in small, short-term profits – a process commonly known as scalping. In some cases, however, they are unable to do so, thereby forcing them to either hold exposed positions or find other parties with whom they can trade and thus lay off (get rid of) the risk. This is when speculators come in. Although speculators are market participants who are willing to take risks, it is important to understand that being a speculator does not mean the reckless assumption of risk. Although speculators will take large losses at times, good speculators manage those risks by watching their exposures, absorbing market information, and observing the flow of orders in such a manner that they are able to survive and profit. Often, speculators will hedge their risks when they become uncomfortable.
Standardization also facilitates the creation of a clearing and settlement operation. Clearing refers to the process by which the exchange verifies the execution of a transaction and records the participants’ identities. Settlement refers to the related process in which the exchange transfers money from one participant to the other or from a participant to the exchange or vice versa. This flow of money is a critical element of derivatives trading. Clearly, there would be no confidence in markets in which money is not efficiently collected and disbursed. Derivatives exchanges have done an excellent job of clearing and settlement, especially in comparison to securities exchanges. Derivatives exchanges clear and settle all contracts overnight, whereas most securities exchanges require two business days.
The clearing and settlement process of derivative transactions also provides a credit guarantee. If two parties engage in a derivative contract on an exchange, one party will ultimately make money and the other will lose money. Derivatives exchanges use their clearinghouses to provide a guarantee to the winning party that if the loser does not pay, the clearinghouse will pay the winning party. The clearinghouse is able to provide this credit guarantee by requiring a cash deposit, usually called the margin bond or performance bond, from the participants to the contract. Derivatives clearinghouses manage these deposits, occasionally requiring additional deposits, so effectively that they have never failed to pay in the nearly 100 years they have existed. We will say more about this process later and illustrate how it works.
Exchange markets are said to have transparency, which means that full information on all transactions is disclosed to exchanges and regulatory bodies. All transactions are centrally reported within the exchanges and their clearinghouses, and specific laws require that these markets be overseen by national regulators. Although this would seem a strong feature of exchange markets, there is a
It is important to understand that merely being able to buy and sell a derivative, or even a security, does not mean that liquidity is high and that the cost of liquidity is low. Derivatives exchanges guarantee that a derivative can be bought and sold, but they do not guarantee the price. The ask price (the price at which the market maker will sell) and the bid price (the price at which the market maker will buy) can be far apart, which they will be in a market with low liquidity. Hence, such a market can have liquidity, loosely defined, but the cost of liquidity can be quite high. The factors that can lead to low liquidity for derivatives are similar to those for securities: little trading interest and a high level of uncertainty.
Exchanges are owned by their
