In a previous article, we introduced the
CFA Institute Investment Foundation Program (Read
more here). It is a free program
designed for anyone who wants to enter or advance within the investment
management industry, including IT, operations, accounting, administration, and
marketing. Candidates who successfully
pass the online exam earn the CFA Institute Investment Foundations Certificate.
There are total of 20 Chapters in 7
modules, covering all the essential topics in finance, economics, ethics and
regulations. This series of articles
will highlight the core knowledge of each chapter.
Chapter 11 provides an overview of derivatives.
The learning outcome of chapter 11 is as follows:
·
Define
a derivative contract;
·
Describe
uses of derivative contracts;
·
Describe
key terms of derivative contracts;
·
Describe
forwards and futures;
·
Distinguish
between forwards and futures;
·
Describe
options and their uses;
·
Define
swaps and their uses.
A forward contract is an
agreement between two parties in which one party agrees to buy from the seller
an underlying at a later date for a price established at the start of the
contract. The future date can be in one month, in one year, in five years, or
at any other specified date. Investors primarily use forward contracts to lock
in the price of an underlying and to gain certainty about future financial
outcomes. Example 1 continues the story of the farmer and describes a forward
contract between the farmer and a cereal producer.
The risk that the other party to the
contract will not fulfil its contractual obligations is called counterparty
risk. To reduce counterparty risk, the parties to a forward contract
evaluate the default risk of the other party before entering into a contract.
If the risk of default is significant, the parties may not agree to a forward
contract. Or one or both parties may require a performance bond. A
performance bond is a guarantee, usually provided by a third party, such as an
insurance company, to ensure payment in case a party fails to fulfil its
contractual obligations (defaults). As an alternative to a performance bond,
collateral may be requested. Collateral refers to pledged assets. That is, if
one party cannot fulfil its contractual obligations, the other party can keep
the collateral as compensation.
No payment on the contract is required
by either party prior to delivery. At expiration, forward contracts usually
settle with physical delivery. At settlement, one party will lose and the other
party will gain relative to the spot price at the expiration date—this price
variance also serves to increase counterparty risk.
A futures contract is similar to
a forward contract in that it is an agreement that obligates the seller, at a
specified future date, to deliver to the buyer a specified underlying in
exchange for the specified futures price. The buyer of the contract is obligated
to take delivery of the underlying, and the seller of the contract is obligated
to deliver the underlying, although settlement may be with cash. The main
difference is that futures contracts are standardised contracts that trade on
exchanges. The buyers and sellers do not necessarily know who is on the other
side of the contract. Because the contracts are traded on exchanges, they are
liquid and it is possible for a buyer or seller to close out a position by
taking the opposite side. In other words, the buyer of a contract can sell the
same contract and the seller of a contract can buy the same contract.
Forwards and futures differ in how they
trade, the flexibility of key terms in the contract, liquidity, counterparty
risk, transaction costs, timing of cash flows, and settlement.
Exhibit 1 provides a comparison of
forward and futures contracts.
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