Friday 13 September 2019

CFA Institute Investment Foundations Program: Chapter 11 – Derivatives (Part II)


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.






Relative to a futures contract, an advantage of a forward contract is:
 
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