CFA Level 1: Derivatives

Derivative (L1)

A security that derives its value from an underlying asset, index, or rate.

Underlying (L1)

The asset, index, or rate on which a derivative's value is based. It can include stocks, bonds, commodities, or market indices.

Exchange Traded Derivatives (L1)

• Derivatives with standardized contracts, (pre-written, pre-approved legal agreements with fixed terms used for common transactions, allowing little to no negotiation.)

• More liquid, more transparent, and lower cost.

• More efficient clearing & settlement.

• Central Clearing: Collateral deposits, mark to market, clearinghouse takes the other side of each trade; minimize counter party risk.

OTC Derivatives (L1)

• Derivatives with customizable contracts (pre-written, pre-approved legal agreements with fixed terms used for common transactions, allowing little to no negotiation.)

• Less liquid and transparent, and higher trading costs.

• Required to have central clearing party & collateral deposit: reduces counterparty risk, similar to exchange-traded derivatives.

• Systemic risk is the most concerning risk

Forward Commitments (L1)

• Agreements made today for a future transaction at a predetermined price.

• Future, Forward contracts, and swaps are examples.

Contingent Claims (L1)

• a derivative whose payoff and value are entirely dependent upon the occurrence of a specific future event.

• Certain conditions are met and satisfied by one party.

• Examples: Options & credit derivatives.

Central Clearing (L1)

A process where a central counterparty (clearinghouse) interposes itself between two parties of a transaction, becoming the buyer to every seller and the seller to every buyer. It involves:

• Collateral deposits: Participants provide margin to cover potential losses.

• Mark-to-market: Daily revaluation of positions and adjustment of collateral to reflect current market prices.

• Clearinghouse roles: The clearinghouse guarantees the performance of contractual obligations, significantly minimizing counterparty risk for participants.

Novation (L1)

In the context of derivatives, novation is the process where a clearinghouse replaces the original bilateral contract between two parties with two new contracts:

• One between the first party and the clearinghouse, and another between the second party and the clearinghouse.

• This effectively makes the clearinghouse the counterparty to both original parties, centralizing risk and facilitating clearing and settlement.

Clearinghouse (L1)

A central financial institution that acts as an intermediary (central counterparty) in financial markets, especially for derivatives and exchange-traded contracts. It becomes the "buyer to every seller" and the "seller to every buyer," guaranteeing the fulfillment of contractual obligations. Its main responsibilities include:

- Mitigating Counterparty Risk: By interposing itself between parties, it minimizes the risk that one party defaults on its obligations.

- Standardizing Clearing and Settlement: It ensures uniform procedures for trade processing.

- Managing Collateral: It requires participants to post margin (collateral deposits) and performs daily mark-to-market valuations to cover potential losses.

Risk Transfer (L3)

The ability to buy or sell a derivative today eliminates the timing mismatch between an economic decision.

Cash Flow Hedge (L3)

A derivative designated as absorbing the variable cash flow of a floating rate asset or liability.

Hedge Accounting (L3)

Gains or losses on derivative offset the effects of changing asset & liability values.

Operational Advantage (L3)

Future margin requirements are quite low vs cost of a cash market purchase.

Price Discovery Function (L3)

Investors track an equity index future prices to gauge sentiment before the market opens.

Transparency (L3)

A type of derivative risk in which portfolio & risk exposures is not understood by investors.

Basic Risk (L3)

A type of derivative risk in which underlying mismatch with hedged risk, or mismatch of expiration data & date hedged transaction.

Systemic Risk (L3)

A type of derivative risk in which excessive speculations may have negative impact on financial markets and institution.

Net Investment Hedge (L3)

A derivative designated as offsetting the foreign exchange risk of the equity of a foreign operation.

Net Value Hedge (L3)

Hedging the value of a foreign subsidiaries’ equity in a parent subsidiaries’ balance sheet with currency forward.