Derivatives
Description
Derivatives is the definitive guide to derivatives and derivative markets. Written by experts working with CFA Institute, this book is an authoritative reference for students and investment professionals interested in the role of derivatives within comprehensive portfolio management. General discussion of the types of derivatives and their characteristics gives way to detailed examination of each market and its contracts, including forwards, futures, options, and swaps, followed by a look at credit derivative markets and their instruments. The companion workbook (sold separately) provides problems and solutions that align with the text and allows students to test their understanding while facilitating deeper internalization of the material.
Derivatives have become essential for effective financial risk management and for creating synthetic exposure to asset classes. This book builds a conceptual framework for grasping derivative fundamentals, with systematic coverage and thorough explanations. Readers will:
* Understand the different types of derivatives and their characteristics
* Delve into the various markets and their associated contracts
* Examine the role of derivatives in portfolio management
* Learn why derivatives are increasingly fundamental to risk management
CFA Institute is the world's premier association for investment professionals, and the governing body for CFA¯® Program, CIPM¯® Program, CFA Institute ESG Investing Certificate, and Investment Foundations¯® Program. Those seeking a deeper understanding of the markets, mechanisms, and use of derivatives will value the level of expertise CFA Institute brings to the discussion, providing a clear, comprehensive resource for students and professionals alike. Whether used alone or in conjunction with the companion workbook, Derivatives offers a complete course in derivatives and their use in investment management.
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Content
Foreword xvii
Preface xix
Acknowledgments xxi
About the CFA Institute Investment Series xxiii
Chapter 1 Derivative Markets and Instruments 1
Learning Outcomes 1
1. Derivatives: Introduction, Definitions, and Uses 1
2. The Structure of Derivative Markets 5
2.1. Exchange-Traded Derivatives Markets 6
2.2. Over-the-Counter Derivatives Markets 8
3. Types of Derivatives: Introduction, Forward Contracts 10
3.1. Forward Commitments 10
4. Types of Derivatives: Futures 14
5. Types of Derivatives: Swaps 18
6. Contingent Claims: Options 22
6.1. Options 22
7. Contingent Claims: Credit Derivatives 30
8. Types of Derivatives: Asset-Backed Securities and Hybrids 33
8.1. Hybrids 35
9. Derivatives Underlyings 36
9.1. Equities 36
9.2. Fixed-Income Instruments and Interest Rates 36
9.3. Currencies 37
9.4. Commodities 37
9.5. Credit 37
9.6. Other 37
10. The Purposes and Benefits of Derivatives 39
10.1. Risk Allocation, Transfer, and Management 40
10.2. Information Discovery 41
10.3. Operational Advantages 41
10.4. Market Efficiency 42
11. Criticisms and Misuses of Derivatives 42
11.1. Speculation and Gambling 43
11.2. Destabilization and Systemic Risk 43
12. Elementary Principles of Derivative Pricing 45
12.1. Storage 46
12.2. Arbitrage 47
Summary 52
Problems 54
Chapter 2 Basics of Derivative Pricing and Valuation 61
Learning Outcomes 61
1. Introduction 62
2. Basic Derivative Concepts, Pricing the Underlying 62
2.1. Basic Derivative Concepts 62
2.2. Pricing the Underlying 64
3. The Principle of Arbitrage 68
3.1. The (In)Frequency of Arbitrage Opportunities 69
3.2. Arbitrage and Derivatives 69
3.3. Arbitrage and Replication 70
3.4. Risk Aversion, Risk Neutrality, and Arbitrage-Free Pricing 71
3.5. Limits to Arbitrage 72
4. Pricing and Valuation of Forward Contracts: Pricing vs. Valuation; Expiration; Initiation 74
4.1. Pricing and Valuation of Forward Commitments 75
5. Pricing and Valuation of Forward Contracts: Between Initiation and Expiration; Forward Rate Agreements 79
5.1. A Word about Forward Contracts on Interest Rates 80
6. Pricing and Valuation of Futures Contracts 82
7. Pricing and Valuation of Swap Contracts 84
8. Pricing and Valuation of Options 87
8.1. European Option Pricing 88
9. Lower Limits for Prices of European Options 94
10. Put-Call Parity, Put-Call-Forward Parity 97
10.1. Put-Call-Forward Parity 101
11. Binomial Valuation of Options 103
12. American Option Pricing 107
Summary 110
Problems 111
Chapter 3 Pricing and Valuation of Forward Commitments 117
Learning Outcomes 117
1. Introduction to Pricing and Valuation of Forward Commitments 117
1.1. Principles of Arbitrage-Free Pricing and Valuation of Forward Commitments 118
1.2. Pricing and Valuing Generic Forward and Futures Contracts 119
2. Carry Arbitrage 124
2.1. Carry Arbitrage Model When There Are No Underlying Cash Flows 124
2.2. Carry Arbitrage Model When Underlying Has Cash Flows 131
3. Pricing Equity Forwards and Futures 135
3.1. Equity Forward and Futures Contracts 135
3.2. Interest Rate Forward and Futures Contracts 138
4. Pricing Fixed-Income Forward and Futures Contracts 147
4.1. Comparing Forward and Futures Contracts 153
5. Pricing and Valuing Swap Contracts 154
5.1. Interest Rate Swap Contracts 156
6. Pricing and Valuing Currency Swap Contracts 163
7. Pricing and Valuing Equity Swap Contracts 171
Summary 176
Problems 179
Chapter 4 Valuation of Contingent Claims 187
Learning Outcomes 187
1. Introduction and Principles of a No- Arbitrage Approach to Valuation 188
1.1. Principles of a No- Arbitrage Approach to Valuation 188
2. Binomial Option Valuation Model 190
3. One- Period Binomial Model 192
4. Binomial Model: Two- Period (Call Options) 199
5. Binomial Model: Two- Period (Put Options) 203
6. Binomial Model: Two- Period (Role of Dividends & Comprehensive Example) 207
7. Interest Rate Options & Multiperiod Model 213
7.1. Multiperiod Model 215
8. Black-Scholes-Merton (BSM) Option Valuation Model, Introduction and Assumptions of the BSM Model 216
8.1. Introductory Material 216
8.2. Assumptions of the BSM Model 216
9. BSM Model: Components 218
10. BSM Model: Carry Benefits and Applications 222
11. Black Option Valuation Model and European Options on Futures 226
11.1. European Options on Futures 226
12. Interest Rate Options 228
13. Swaptions 232
14. Option Greeks and Implied Volatility: Delta 234
14.1. Delta 235
15. Gamma 238
16. Theta 241
17. Vega 242
18. Rho 243
19. Implied Volatility 244
Summary 247
Problems 249
Chapter 5 Credit Default Swaps 255
Learning Outcomes 255
1. Introduction 255
2. Basic Definitions and Concepts 255
2.1. Types of CDS 257
3. Important Features of CDS Markets and Instruments, Credit and Succession Events, and Settlement Proposals 258
3.1. Credit and Succession Events 260
3.2. Settlement Protocols 261
3.3. CDS Index Products 262
3.4. Market Characteristics 264
4. Basics of Valuation and Pricing 265
4.1. Basic Pricing Concepts 265
4.2. The Credit Curve and CDS Pricing Conventions 268
4.3. CDS Pricing Conventions 269
4.4. Valuation Changes in CDS during Their Lives 270
4.5. Monetizing Gains and Losses 271
5. Applications of CDS 272
5.1. Managing Credit Exposures 273
6. Valuation Differences and Basis Trading 277
Summary 279
Problems 280
Chapter 6 Introduction to Commodities and Commodity Derivatives 285
Learning Outcomes 285
1. Introduction 285
2. Commodity Sectors 286
2.1. Commodity Sectors 288
3. Life Cycle of Commodities 290
3.1. Energy 291
3.2. Industrial/Precious Metals 292
3.3. Livestock 294
3.4. Grains 295
3.5. Softs 295
4. Valuation of Commodities 296
5. Commodities Futures Markets: Participants 298
5.1. Futures Market Participants 298
6. Commodity Spot and Futures Pricing 302
7. Theories of Futures Returns 306
7.1. Theories of Futures Returns 306
8. Components of Futures Returns 313
9. Contango, Backwardation, and the Roll Return 317
10. Commodity Swaps 320
10.1. Total Return Swap 322
10.2. Basis Swap 323
10.3. Variance Swaps and Volatility Swaps 323
11. Commodity Indexes 324
11.1. S&p Gsci 327
11.2. Bloomberg Commodity Index 327
11.3. Deutsche Bank Liquid Commodity Index 327
11.4. Thomson Reuters/CoreCommodity CRB Index 327
11.5. Rogers International Commodity Index 328
11.6. Rebalancing Frequency 328
11.7. Commodity Index Summary 328
Summary 329
References 331
Problems 331
Chapter 7 Currency Management: An Introduction 339
Learning Outcomes 339
1. Introduction 340
2. Review of Foreign Exchange Concepts 340
2.1. Spot Markets 341
2.2. Forward Markets 343
2.3. FX Swap Markets 346
2.4. Currency Options 347
3. Currency Risk and Portfolio Risk and Return 347
3.1. Return Decomposition 347
3.2. Volatility Decomposition 350
4. Strategic Decisions in Currency Management: Overview 353
4.1. The Investment Policy Statement 354
4.2. The Portfolio Optimization Problem 354
4.3. Choice of Currency Exposures 356
5. Strategic Decisions in Currency Management: Spectrum of Currency Risk Management Strategies 359
5.1. Passive Hedging 359
5.2. Discretionary Hedging 359
5.3. Active Currency Management 360
5.4. Currency Overlay 360
6. Strategic Decisions in Currency Management: Formulating a Currency Management Program 363
7. Active Currency Management: Based on Economic Fundamentals, Technical Analysis, and the Carry Trade 365
7.1. Active Currency Management Based on Economic Fundamentals 365
7.2. Active Currency Management Based on Technical Analysis 367
7.3. Active Currency Management Based on the Carry Trade 368
8. Active Currency Management: Based on Volatility Trading 370
9. Currency Management Tools: Forward Contracts, FX Swaps, and Currency Options 375
9.1. Forward Contracts 376
9.2. Currency Options 383
10. Currency Management Strategies 385
10.1. Over- /Under- Hedging Using Forward Contracts 386
10.2. Protective Put Using OTM Options 387
10.3. Risk Reversal (or Collar) 387
10.4. Put Spread 388
10.5. Seagull Spread 388
10.6. Exotic Options 389
10.7. Section Summary 390
11. Hedging Multiple Foreign Currencies 393
11.1. Cross Hedges and Macro Hedges 393
11.2. Minimum- Variance Hedge Ratio 397
11.3. Basis Risk 397
12. Currency Management Tools and Strategies: A Summary 400
13. Currency Management for Emerging Market Currencies 404
13.1. Special Considerations in Managing Emerging Market Currency Exposures 404
13.2. Non- Deliverable Forwards 406
Summary 407
References 409
Problems 410
Chapter 8 Options Strategies 421
Learning Outcomes 421
1. Introduction 422
2. Position Equivalencies 422
2.1. Synthetic Forward Position 423
2.2. Synthetic Put and Call 426
3. Covered Calls and Protective Puts 428
3.1. Investment Objectives of Covered Calls 428
4. Investment Objectives of Protective Puts 436
4.1. Loss Protection/Upside Preservation 437
4.2. Profit and Loss at Expiration 439
5. Equivalence to Long Asset/Short Forward Position 441
5.1. Writing Puts 442
6. Risk Reduction Using Covered Calls and Protective Puts 444
6.1. Covered Calls 445
6.2. Protective Puts 445
6.3. Buying Calls and Writing Puts on a Short Position 445
7. Spreads and Combinations 448
7.1. Bull Spreads and Bear Spreads 448
8. Straddle 457
8.1. Collars 460
8.2. Calendar Spread 463
9. Implied Volatility and Volatility Skew 465
10. Investment Objectives and Strategy Selection 469
10.1. The Necessity of Setting an Objective 469
10.2. Criteria for Identifying Appropriate Option Strategies 470
11. Uses of Options in Portfolio Management 472
11.1. Covered Call Writing 472
11.2. Put Writing 474
11.3. Long Straddle 475
11.4. Collar 478
11.5. Calendar Spread 478
12. Hedging an Expected Increase in Equity Market Volatility 480
12.1. Establishing or Modifying Equity Risk Exposure 482
Summary 485
Problems 487
Chapter 9 Swaps, Forwards, and Futures Strategies 493
Learning Outcomes 493
1. Managing Interest Rate Risk with Swaps 493
1.1. Changing Risk Exposures with Swaps, Futures, and Forwards 494
2. Managing Interest Rate Risk with Forwards, Futures, and Fixed- Income Futures 498
2.1. Fixed- Income Futures 500
3. Managing Currency Exposure 506
3.1. Currency Swaps 506
3.2. Currency Forwards and Futures 510
4. Managing Equity Risk 511
4.1. Equity Swaps 511
4.2. Equity Forwards and Futures 513
4.3. Cash Equitization 516
5. Volatility Derivatives: Futures and Options 517
5.1. Volatility Futures and Options 518
6. Volatility Derivatives: Variance Swaps 520
7. Using Derivatives to Manage Equity Exposure and Tracking Error 523
7.1. Cash Equitization 524
8. Using Derivatives in Asset Allocation 525
8.1. Changing Allocations between Asset Classes Using Futures 525
8.2. Rebalancing an Asset Allocation Using Futures 528
8.3. Changing Allocations between Asset Classes Using Swaps 529
9. Using Derivatives to Infer Market Expectations 531
9.1. Using Fed Funds Futures to Infer the Expected Average Federal Funds Rate 531
9.2. Inferring Market Expectations 533
Summary 534
Problems 535
Chapter 10 Introduction to Risk Management 543
Learning Outcomes 543
1. Introduction 543
2. The Risk Management Process 545
3. The Risk Management Framework 547
4. Risk Governance - An Enterprise View 554
4.1. An Enterprise View of Risk Governance 554
5. Risk Tolerance 556
6. Risk Budgeting 558
7. Identification of Risk - Financial and Non- Financial Risk 561
7.1. Financial Risks 561
7.2. Non- Financial Risks 563
8. Identification of Risk - Interactions Between Risks 567
9. Measuring and Modifying Risk - Drivers and Metrics 571
9.1. Drivers 571
9.2. Metrics 572
10. Methods of Risk Modification - Prevention, Avoidance, and Acceptance 576
10.1. Risk Prevention and Avoidance 577
10.2. Risk Acceptance: Self- Insurance and Diversification 578
11. Methods of Risk Modification - Transfer, Shifting, Choosing a Method for Modifying 579
11.1. Risk Shifting 581
11.2. How to Choose Which Method for Modifying Risk 583
Summary 585
Problems 587
Chapter 11 Measuring and Managing Market Risk 591
Learning Outcomes 591
1. Introduction 592
1.1. Understanding Value at Risk 592
2. Estimating VaR 596
3. The Parametric Method of VaR Estimation 598
4. The Historical Simulation Method of VaR Estimation 602
5. The Monte Carlo Simulation Method of VaR Estimation 605
6. Advantages and Limitations of VaR and Extensions of VaR 608
6.1. Advantages of VaR 608
6.2. Limitations of VaR 609
6.3. Extensions of VaR 611
7. Other Key Risk Measures - Sensitivity Risk Measures; Sensitivity Risk Measures 613
7.1. Sensitivity Risk Measures 614
8. Scenario Risk Measures 618
8.1. Historical Scenarios 618
8.2. Hypothetical Scenarios 620
9. Sensitivity and Scenario Risk Measures and VaR 623
9.1. Advantages and Limitations of Sensitivity Risk Measures and Scenario Risk Measures 624
10. Using Constraints in Market Risk Management 627
10.1. Risk Budgeting 628
10.2. Position Limits 629
10.3. Scenario Limits 629
10.4. Stop- Loss Limits 630
10.5. Risk Measures and Capital Allocation 630
11. Applications of Risk Measures 632
11.1. Market Participants and the Different Risk Measures They Use 632
12. Pension Funds and Insurers 637
12.1. Insurers 639
Summary 641
Reference 643
Problems 643
Chapter 12 Risk Management for Individuals 651
Learning Outcomes 651
1. Introduction 652
2. Human Capital, Financial Capital, and Economic Net Worth 652
2.1. Human Capital 653
2.2. Financial Capital 656
2.3. Economic Net Worth 661
3. A Framework for Individual Risk Management 661
3.1. The Risk Management Strategy for Individuals 661
3.2. Financial Stages of Life 662
4. The Individual Balance Sheet 665
4.1. Traditional Balance Sheet 665
4.2. Economic (Holistic) Balance Sheet 666
4.3. Changes in Economic Net Worth 668
5. Individual Risk Exposures 671
5.1. Earnings Risk 671
5.2. Premature Death Risk 672
5.3. Longevity Risk 673
5.4. Property Risk 674
5.5. Liability Risk 674
5.6. Health Risk 675
6. Life Insurance: Uses, Types, and Elements 676
6.1. Life Insurance 677
7. Life Insurance: Pricing, Policy Cost Comparison, and Determining Amount Needed 680
7.1. Mortality Expectations 680
7.2. Calculation of the Net Premium and Gross Premium 682
7.3. Cash Values and Policy Reserves 684
7.4. Consumer Comparisons of Life Insurance Costs 685
7.5. How Much Life Insurance Does One Need? 687
8. Other Types of Insurance 688
8.1. Property Insurance 690
8.2. Health/Medical Insurance 692
8.3. Liability Insurance 693
8.4. Other Types of Insurance 693
9. Annuities: Types, Structure, and Classification 694
9.1. Parties to an Annuity Contract 694
9.2. Classification of Annuities 695
10. Annuities: Advantages and Disadvantages of Fixed and Variable Annuities 698
10.1. Volatility of Benefit Amount 698
10.2. Flexibility 699
10.3. Future Market Expectations 699
10.4. Fees 700
10.5. Inflation Concerns 700
10.6. Payout Methods 700
10.7. Annuity Benefit Taxation 701
10.8. Appropriateness of Annuities 701
11. Risk Management Implementation: Determining the Optimal Strategy and Case Analysis 703
11.1. Determining the Optimal Risk Management Strategy 703
11.2. Analyzing an Insurance Program 705
12. The Effect of Human Capital on Asset Allocation and Risk Reduction 712
12.1. Asset Allocation and Risk Reduction 716
Summary 718
References 720
Problems 720
Chapter 13 Case Study in Risk Management: Private Wealth 727
Learning Outcomes 727
1. Introduction and Case Background 727
1.1. Background of Eurolandia 728
1.2. The Schmitt Family in Their Early Career Stage 730
Summary 772
Problems 773
Chapter 14 Integrated Cases in Risk Management: Institutional 777
Learning Outcomes 777
1. Introduction 777
2. Financial Risks Faced by Institutional Investors 778
References 831
Glossary 833
About the Editors and Authors 845
Index 849
CHAPTER 1
DERIVATIVE MARKETS AND INSTRUMENTS
Don M. Chance, PhD, CFA
LEARNING OUTCOMES
The candidate should be able to:
- define a derivative and distinguish between exchange-traded and over-the-counter derivatives;
- contrast forward commitments with contingent claims;
- define forward contracts, futures contracts, options (calls and puts), swaps, and credit derivatives and compare their basic characteristics;
- determine the value at expiration and profit from a long or a short position in a call or put option;
- describe purposes of, and controversies related to, derivative markets;
- explain arbitrage and the role it plays in determining prices and promoting market efficiency.
1. DERIVATIVES: INTRODUCTION, DEFINITIONS, AND USES
Equity, fixed-income, currency, and commodity markets are facilities for trading the basic assets of an economy. Equity and fixed-income securities are claims on the assets of a company. Currencies are the monetary units issued by a government or central bank. Commodities are natural resources, such as oil or gold. These underlying assets are said to trade in cash markets or spot markets and their prices are sometimes referred to as cash prices or spot prices, though we usually just refer to them as stock prices, bond prices, exchange rates, and commodity prices. These markets exist around the world and receive much attention in the financial and mainstream media. Hence, they are relatively familiar not only to financial experts but also to the general population.
Somewhat less familiar are the markets for derivatives, which are financial instruments that derive their values from the performance of these basic assets. This reading is an overview of derivatives. Subsequent readings will explore many aspects of derivatives and their uses in depth. Among the questions that this first reading will address are the following:
- What are the defining characteristics of derivatives?
- What purposes do derivatives serve for financial market participants?
- What is the distinction between a forward commitment and a contingent claim?
- What are forward and futures contracts? In what ways are they alike and in what ways are they different?
- What are swaps?
- What are call and put options and how do they differ from forwards, futures, and swaps?
- What are credit derivatives and what are the various types of credit derivatives?
- What are the benefits of derivatives?
- What are some criticisms of derivatives and to what extent are they well founded?
- What is arbitrage and what role does it play in a well-functioning financial market?
This reading is organized as follows. Section 1 explores the definition and uses of derivatives and establishes some basic terminology. Section 2 describes derivatives markets. Sections 3-9 categorize and explain types of derivatives. Sections 10 and 11 discuss the benefits and criticisms of derivatives, respectively. Section 12 introduces the basic principles of derivative pricing and the concept of arbitrage.
Derivatives: Definitions and Uses
The most common definition of a derivative reads approximately as follows:
A derivative is a financial instrument that derives its performance from the performance of an underlying asset.
This definition, despite being so widely quoted, can nonetheless be a bit troublesome. For example, it can also describe mutual funds and exchange-traded funds, which would never be viewed as derivatives even though they derive their values from the values of the underlying securities they hold. Perhaps the distinction that best characterizes derivatives is that they usually transform the performance of the underlying asset before paying it out in the derivatives transaction. In contrast, with the exception of expense deductions, mutual funds and exchange-traded funds simply pass through the returns of their underlying securities. This transformation of performance is typically understood or implicit in references to derivatives but rarely makes its way into the formal definition. In keeping with customary industry practice, this characteristic will be retained as an implied, albeit critical, factor distinguishing derivatives from mutual funds and exchange-traded funds and some other straight pass-through instruments. Also, note that the idea that derivatives take their performance from an underlying asset encompasses the fact that derivatives take their value and certain other characteristics from the underlying asset. Derivatives strategies perform in ways that are derived from the underlying and the specific features of derivatives.
Derivatives are similar to insurance in that both allow for the transfer of risk from one party to another. As everyone knows, insurance is a financial contract that provides protection against loss. The party bearing the risk purchases an insurance policy, which transfers the risk to the other party, the insurer, for a specified period of time. The risk itself does not change, but the party bearing it does. Derivatives allow for this same type of transfer of risk. One type of derivative in particular, the put option, when combined with a position exposed to the risk, functions almost exactly like insurance, but all derivatives can be used to protect against loss. Of course, an insurance contract must specify the underlying risk, such as property, health, or life. Likewise, so do derivatives. As noted earlier, derivatives are associated with an underlying asset. As such, the so-called "underlying asset" is often simply referred to as the underlying, whose value is the source of risk. In fact, the underlying need not even be an asset itself. Although common derivatives underlyings are equities, fixed-income securities, currencies, and commodities, other derivatives underlyings include interest rates, credit, energy, weather, and even other derivatives, all of which are not generally thought of as assets. Thus, like insurance, derivatives pay off on the basis of a source of risk, which is often, but not always, the value of an underlying asset. And like insurance, derivatives have a definite life span and expire on a specified date.
Derivatives are created in the form of legal contracts. They involve two parties-the buyer and the seller (sometimes known as the writer)-each of whom agrees to do something for the other, either now or later. The buyer, who purchases the derivative, is referred to as the long or the holder because he owns (holds) the derivative and holds a long position. The seller is referred to as the short because he holds a short position.1
A derivative contract always defines the rights and obligations of each party. These contracts are intended to be, and almost always are, recognized by the legal system as commercial contracts that each party expects to be upheld and supported in the legal system. Nonetheless, disputes sometimes arise, and lawyers, judges, and juries may be required to step in and resolve the matter.
There are two general classes of derivatives. Some provide the ability to lock in a price at which one might buy or sell the underlying. Because they force the two parties to transact in the future at a previously agreed-on price, these instruments are called forward commitments. The various types of forward commitments are called forward contracts, futures contracts, and swaps. Another class of derivatives provides the right but not the obligation to buy or sell the underlying at a pre-determined price. Because the choice of buying or selling versus doing nothing depends on a particular random outcome, these derivatives are called contingent claims. The primary contingent claim is called an option. The types of derivatives will be covered in more detail later in this reading and in considerably more depth later in the curriculum.
The existence of derivatives begs the obvious question of what purpose they serve. If one can participate in the success of a company by holding its equity, what reason can possibly explain why another instrument is required that takes its value from the performance of the equity? Although equity and other fundamental markets exist and usually perform reasonably well without derivative markets, it is possible that derivative markets can improve the performance of the markets for the underlyings. As you will see later in this reading, that is indeed true in practice.
Derivative markets create beneficial opportunities that do not exist in their absence. Derivatives can be used to create strategies that cannot be implemented with the underlyings alone. For example, derivatives make it easier to go short, thereby benefiting from a decline in the value of the underlying. In addition, derivatives, in and of themselves, are characterized by a relatively high degree of leverage, meaning that participants in derivatives transactions usually have to invest only a small amount of their own capital relative to the value of the underlying. As such, small movements in the underlying can lead to fairly large movements in the amount of money made or lost on the derivative. Derivatives generally trade at lower transaction costs than comparable spot market transactions, are often more liquid than their...
