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CFA® Level I · Derivatives · free lesson
Derivative Instrument and Derivative Market Features
Derivatives let companies, investors and banks buy or sell exposure to a price, rate or event without trading the asset itself. This module defines what a derivative is, surveys the underlyings on which derivatives are written, contrasts exchange-traded and over-the-counter markets, and explains how central clearing and margin manage the counterparty risk that sits at the heart of every derivative contract.
What you will learn
1. Define a derivative and describe its basic features, including the underlying, contract size, maturity, settlement method and the positions of the two counterparties.
- A derivative's value depends on an underlying asset, rate, index or event.
- Core terms: underlying, contract size, maturity, contract price or rate, settlement method.
- Settlement is by physical delivery or by a cash payment of the gain or loss.
- The long gains when the underlying rises; the short gains when it falls; the contract is zero-sum.
- Notional amount measures exposure; market value is usually far smaller, which creates implicit leverage.
2. Identify the main categories of underlyings on which derivatives are written and explain how each category is used.
- Main categories: equities, fixed income and interest rates, currencies, commodities, credit, and other.
- Interest rate contracts are the largest segment by notional amount.
- Commodity contracts are often physically settled and reflect storage and transport costs.
- Credit derivatives pay out on a credit event of a reference entity.
- Any underlying needs a reliable, independently observable value for settlement.
3. Compare exchange-traded and over-the-counter derivative markets in terms of standardization, customization, transparency, liquidity and counterparty risk.
- ETDs: standardized terms, exchange trading, central clearing, daily margin, high transparency and liquidity.
- OTC: privately negotiated, customizable, dealer-intermediated, historically less transparent.
- Uncleared OTC contracts expose each party to the other's default risk.
- Standardization buys liquidity at the cost of an imperfect fit for the hedger.
- Post-2008 rules push standardized OTC contracts toward clearing and reporting.
4. Explain how central counterparties, margin, novation and netting reduce counterparty credit risk, and describe the post-2008 reforms of OTC derivatives markets.
- Novation makes the CCP the counterparty to both sides of every cleared trade.
- Initial margin covers potential future losses; variation margin settles realized gains and losses daily.
- Default waterfall: defaulter's margin, defaulter's default fund, CCP capital, then other members' funds.
- Multilateral netting replaces many gross payments with one net payment per member.
- Post-2008 reforms: mandatory clearing, trade reporting, platform trading and margin for uncleared trades.
Module at a glance
- A derivative derives its value from an underlying asset, rate, index or event.
- Notional amount measures exposure; market value is usually much smaller, creating implicit leverage.
- Underlyings: equities, interest rates and bonds, currencies, commodities, credit and others such as weather.
- Exchange-traded: standardized, transparent, liquid and centrally cleared; OTC: customized and bilateral.
- A CCP uses novation, initial and variation margin, netting and a default waterfall to contain counterparty risk.
- Post-2008 rules require clearing of standardized OTC contracts, trade reporting and margin on uncleared trades.
This free module has 4 lessons, 14 practice questions with full explanations.