Derivative instruments allow allocation, transfer, and management of risks without trading an underlying. The information on cash or spot market prices for financial instruments, goods, and services may assist an investor or issuer in buying and selling. However, issuers and investors are affected by the timing difference between the economic decision and the ability to transact in a cash market.
The ability to buy or sell a derivative instrument today at a pre-agreed price reduces the time between the economic decision and transacting in price risk under different scenarios. For instance, forward commitments or contingent claims can allocate or transfer risk across time and among investors willing to assume those exposures.
2. Information Discovery
Derivative instrument prices provide a price discovery function outside cash or spot markets. More specifically, futures prices may give information about future cash market movement. For instance:
Analyzing equity index futures prices before the stock market’s opening may indicate the direction of cash market prices in early trading.
Analysts often use the interest rate futures market to predict expectations of the central bank’s benchmark interest rate movement.
Prices for commodity futures serve as a proxy for supply and demand patterns among producers, consumers, and investors across maturities.
Options prices mirror underlying features such as implied volatility, which measures the expected price risk of the underlying.
3. Operational Advantages Compared to Cash or Spot Markets
The operational benefits of derivatives that differentiate them from the cash or spot market include the following:
Lower transaction costs: Derivatives remove the need for insurance, transportation, and storage costs before taking a short position in an underlying.
High liquidity: Derivative markets are associated with reduced capital needed to trade derivatives as compared to a position in cash position in the underlying.
Low upfront cash requirements: Derivatives are associated with low initial margins and premiums compared to cash market transaction costs.
Ability to take short positions with low associated costs.
4. Market Efficiency
Operational efficiency of derivative markets natures greater market efficiency. Derivative markets offer an effective way to exploit mispricing (deviation of prices from the fundamental value). Consequently, fundamental values are frequently reflected earlier in the derivative market than in the cash market. As such, derivative markets lead to more efficient financial markets.
Risks of Derivative Instruments
Derivative instruments and positions are complex. As a result, there are potential risks associated with their usage. These include:
i. High Potential for Speculative Use
High operational efficiency in derivative instruments limits an investor’s initial cash outlay. Consequently, this feature attracts a high degree of implicit leverage compared to cash or spot markets. A high degree of leverage may increase the chances of financial distress.
ii. Lack of Transparency
Derivatives are used to create exposures not found in cash or spot markets. This results in greater portfolio complexity and risks unknown to the investors.
iii. Basis Risk
Basis risk occurs when the expected value of a derivative instrument suddenly deviates from that of the underlying or hedged transaction. Basis risk may manifest when a derivative instrument references a price of an index that is similar but does not precisely match the underlying exposure.
iv. Liquidity Risk
Liquidity risk arises when the cash flow timing of a derivative differs from that of the underlying transaction. For instance, if an investor or issuer fails to honor the margin call requirements, its position is closed out.
v. Counterparty Credit Risk
Counterparty credit risk is the risk of one or more parties in a financial transaction failing to fulfill their side of the contractual agreement. Derivative instruments are associated with counterparty credit exposure leading to differences in the current price compared with the expected future settlement price. However, counterparty credit risk varies with derivatives instrument types and markets in which they are traded.
For example, counterparty credit risk is prevalent in over-the-counter (OTC) markets since credit terms are privately negotiated between counterparties. On the other hand, exchange-traded derivatives are associated with low counterparty risk due to the mark-to-market (MTM) process and margining procedures.
vi. Destabilization and Systemic Risk
Systemic risk occurs due to extensive risk-taking and the use of leverage in derivative markets (which may lead to market stress). As such, financial market supervisory has increased, with a heightened focus on the effect of financial innovation and financial conditions necessary for market stability.
Which of the following best describes basis risk? The risk that:
A. cash flow timing of a derivative instrument differs from that of an underlying transaction.
B. the expected value of the derivative deviates unexpectedly from that of the underlying.
C. arise due to imprudent risk-taking and utilization of leverage that play a part in market stress.
The correct answer is B.
Basis risk occurs when the expected value of a derivative instrument suddenly deviates from that of the underlying or hedged transaction.
A is incorrect. It describes liquidity risk.
C is incorrect. It describes the systemic risk.
Excelente para el FRM 2
Escribo esta revisión en español para los hispanohablantes, soy de Bolivia, y utilicé
AnalystPrep para dudas y consultas sobre mi preparación para el FRM nivel 2 (lo tomé una sola vez y aprobé muy bien), siempre tuve un soporte claro, directo y rápido, el material sale rápido cuando hay cambios en el temario de GARP, y los ejercicios y exámenes son muy útiles para practicar.
So helpful. I have been using the videos to prepare for the CFA Level II exam. The videos signpost the reading contents, explain the concepts and provide additional context for specific concepts.
The fun light-hearted analogies are also a welcome break to some very dry content.
I usually watch the videos before going into more in-depth reading and they are a good way to avoid being overwhelmed by the sheer volume of content when you look at the readings.
A great curriculum provider. James sir explains the concept so well that rather than memorising it, you tend to intuitively understand and absorb them.
Thank you ! Grateful I saw this at the right time for my CFA prep.
Very well explained and gives a great insight about topics in a very short time. Glad to have found Professor Forjan's lectures.
Great support throughout the course by the team, did not feel neglected
I loved using AnalystPrep for FRM.
QBank is huge, videos are great.
Would recommend to a friend
I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.
Trustpilot rating score: 4.5 of 5, based on 69 reviews.