Chapter 1

Part A: Forwards, futures and swaps

Derivative markets and instruments

Last updated November 20269 sectionsabout 9 min read

Key takeaways

A derivative takes its value from an underlying asset, rate or index, and lets specific risks such as price, rate or credit risk pass between parties without necessarily transferring the underlying itself.
Forward commitments (forwards, futures and swaps) oblige both parties to transact; contingent claims (options) give one party a right without an obligation.
Hedgers use derivatives to reduce an existing exposure, speculators to take a directional or volatility view, and arbitrageurs to exploit mispricing, which keeps prices anchored to their no-arbitrage value.
Derivative markets serve price discovery, risk transfer and lower-cost, more flexible exposure, but leverage, complexity and counterparty and systemic risk draw criticism.
Pricing rests on no-arbitrage: positions with identical future payoffs must cost the same today, so a derivative is worth what its replicating portfolio costs.

Derivatives were introduced across earlier papers purely as risk-management and speculative tools (in Introduction to Finance and Investments and in Portfolio Management); this paper develops them into their own full discipline, starting with what a derivative fundamentally is.

What a derivative is

A derivative is a financial instrument whose value is derived from the value of an underlying asset, rate, or index, rather than having independent value of its own; it allows the transfer of specific risks (price, rate, credit) between parties without necessarily transferring the underlying asset itself.

Derivatives terminology

Underlying

The asset, rate or index a derivative's value is derived from, an equity share, a bond, a currency, an interest rate, a commodity.

Notional amount

The reference quantity a derivative contract is based on, used to calculate payments, but (except for physically settled contracts) not itself exchanged.

Long and short positions

The long position benefits from a rise in the underlying's value; the short position benefits from a fall.

Expiration (maturity)

The date the derivative contract's rights and obligations end.

Settlement

How the contract is finally satisfied, physical delivery of the underlying, or cash settlement based on the difference between the contract price and the underlying's market price.

Types of derivatives

Forward commitments

Obligate both parties to transact at a future date on agreed terms: forward contracts, futures contracts and swaps, each covered in its own chapter.

Contingent claims

Give one party a right, but not an obligation, to transact: options (see the chapter on option markets).

Exotic forwards

Range forwards (a forward combined with a collar-like structure, capping and flooring the effective settlement price) and break forwards (allow early termination at a pre-agreed, less favourable rate, effectively bundling in an option).

Exotic options

The common types:

Asian (average-rate) options: payoff based on the underlying's average price over a period, rather than its price at a single expiration date.
Lookback options: payoff based on the most favourable price the underlying reached during the option's life.
Barrier options: activated or extinguished if the underlying crosses a specified price level.

Exotic options: multi-asset and compound types

The types:

Rainbow options: payoff depends on more than one underlying asset.
Compound options: an option on another option.
Chooser options: let the holder decide, at a specified future date, whether the option is a call or a put.

Swap variants

The basic swaps, each with further structural variants (amortising, basis, forward-starting) built on the same underlying exchange-of-cash-flows logic:

Interest rate swaps (see the chapter on swaps) exchanging fixed for floating interest payments.
Currency swaps exchanging cash flows in different currencies.
Equity swaps exchanging an equity return for a fixed or floating rate.

Regulation, participants and trading

Regulation

Exchange-traded derivatives (futures, listed options) are regulated similarly to the underlying securities markets (see Regulation of Financial Markets); OTC derivatives (most forwards and swaps) are more lightly regulated, though post-financial-crisis reforms have pushed increasing standardisation and central clearing even for OTC instruments.

Players

Hedgers, speculators and arbitrageurs (the commodity-market participant categories in Alternative Investments Analysis apply generally across all derivative markets).

Trading of financial versus commodity derivatives

Financial derivatives (on equities, bonds, currencies, rates) trade against purely financial underlyings with no physical delivery complication for most contracts; commodity derivatives (see Alternative Investments Analysis, on commodities) must additionally account for storage, transport and physical delivery logistics where physically settled.

Buying and shorting financial assets

Derivatives let an investor gain the economic equivalent of a long or short position in an underlying asset (the long-short strategies of Equity Investments Analysis) without necessarily owning or physically borrowing the asset itself, often at lower transaction cost and with embedded leverage.

Structure and purpose of derivative markets

Price discovery: derivative prices (particularly futures) reveal the market's collective expectation of the underlying's future price
Risk transfer: shifting specific price, rate or credit risk from those who wish to avoid it to those willing to bear it for compensation
Operational advantages: generally lower transaction costs and greater flexibility to establish or adjust a specific exposure than trading the underlying asset directly

Users and uses of derivatives

Hedgers

Use derivatives to reduce an existing risk exposure (the three risk management chapters develop specific hedging applications in depth).

Speculators

Use derivatives to take a directional or volatility view, often with more leverage and lower transaction cost than trading the underlying directly.

Arbitrageurs

Exploit temporary mispricing between a derivative and its underlying, or between related derivatives, the activity that keeps derivative pricing (see Principles of derivative pricing, below) anchored to its theoretical no-arbitrage value.

Criticisms of derivative markets

Leverage can amplify losses as easily as gains, and has been implicated in several major financial losses and crises
Complexity, particularly of exotic instruments (see Types of derivatives, above), can obscure genuine risk from both users and regulators
Counterparty and systemic risk: interconnected derivative exposures across major institutions can transmit and amplify stress through the financial system (see Corporate Finance, on risk management and financial crises)
Perceived facilitation of speculation disconnected from the underlying real economic activity

Principles of derivative pricing

Derivative pricing rests on the no-arbitrage principle: two positions with identical future payoffs must have the same value today, otherwise a riskless arbitrage profit could be earned by simultaneously buying the cheaper position and selling the more expensive one (the same principle underlying the arbitrage-free bond valuation of Fixed Income Investments Analysis and the arbitrage pricing theory of Equity Investments Analysis); a derivative's value is generally derived by constructing a replicating portfolio of the underlying asset and risk-free borrowing or lending that reproduces the derivative's own payoff exactly.

Size of global and regional markets

Global derivatives markets, spanning exchange-traded futures and options and the much larger OTC forward and swap markets, are measured in notional amounts many multiples of global GDP, though notional amount overstates actual risk exposure since it is a reference quantity, not an amount at risk (see Derivatives terminology, above); markets vary significantly by region and product, with developed markets typically offering deeper, more standardised exchange-traded products and many emerging markets still developing their derivatives infrastructure alongside their underlying cash markets (see Regulation of Financial Markets, on securities exchanges).

Self-check

(a) Distinguish a forward commitment from a contingent claim and give two examples of each. (3 marks)

(b) Define underlying, notional amount and settlement. (3 marks)

(d) State three purposes served by derivative markets. (3 marks)

(e) State three criticisms of derivative markets. (3 marks)

(f) Explain the no-arbitrage principle and the role of a replicating portfolio in derivative pricing. (3 marks)

Show worked answer

(a) A forward commitment obliges both parties to transact on agreed terms at a future date: forwards, futures and swaps. A contingent claim gives one party the right but not the obligation to transact, while the other party is obliged if that right is exercised: call and put options, swaptions.

(b) The underlying is the asset, rate or index from which the derivative's value is derived. The notional amount is the reference quantity used to compute payments, not usually exchanged itself. Settlement is how the contract is finally satisfied, by physical delivery of the underlying or by cash payment of the difference between the contract price and the market price.

(c) An Asian option pays off on the average price of the underlying over a period rather than its price at expiration. A lookback option pays off on the most favourable price reached during its life. A barrier option comes into existence or is extinguished when the underlying crosses a specified price level.

(d) Price discovery, since futures prices reveal the market's expectation of future prices; risk transfer from those who want to shed a risk to those willing to bear it for a price; and operational advantages, lower transaction costs and greater flexibility than trading the underlying.

(e) Leverage amplifies losses and has featured in major failures; complexity can hide risk from users and regulators; interconnected exposures create counterparty and systemic risk; and derivatives can facilitate speculation disconnected from real activity. Any three.

(f) Two positions with identical future payoffs must have the same price today, or an arbitrageur could buy the cheaper and sell the dearer for a riskless profit. A derivative is priced by building a portfolio of the underlying and risk-free borrowing or lending that reproduces its payoff exactly; the derivative must be worth what that replicating portfolio costs.

Exam tip

Forward commitments versus contingent claims (see Types of derivatives) is the paper's most fundamental classification, and the fastest test is symmetry of obligation: both parties are obligated (forwards, futures, swaps) versus only one party has an obligation while the other holds a right (options).