Derivative Benefits, Risks, and Issuer and Investor Uses

This reading weighs the benefits of derivatives against their risks and shows how issuers and investors use them. A candidate must be able to explain the risk-management, information and operational benefits of derivatives, measure the implicit leverage of a margined position, identify basis, liquidity, counterparty and systemic risk, and classify a corporate hedge as a cash flow, fair value or net investment hedge.

LOS 72.a — Benefits and risks of derivatives

Benefits

1. Changing, transferring and managing risk. Without buying or selling any cash market security, a user can raise or lower exposure to an index, hedge the currency risk of expected receipts or payments, or turn a floating-rate liability into a fixed-rate one. Derivatives also create exposures unavailable in cash markets. Buying puts on a stock puts a floor under its sale price, and buying calls gives upside exposure with the loss limited to the premium.
2. Information discovery. Option prices depend on observable inputs (price of the underlying, exercise price, time to expiration, interest rates) and one unobservable input, expected volatility. Option prices therefore reveal the market's implied volatility. Futures and forward prices indicate expected prices of the underlying, and interest rate futures across maturities reveal expected future rates, even the expected number of central bank rate moves.
3. Operational advantages.
   • Ease of short selling: selling a forward or futures contract is simpler than borrowing an asset to short it, especially where borrowing is hard or short sales are restricted.
   • Lower transaction costs: commodity exposure needs no transport, storage or insurance, and entering a swap costs far less than buying back a floating-rate note and replacing it with a new fixed-rate issue.
   • Greater leverage: little cash is needed for a large exposure.
   • Greater liquidity: the small cash requirement makes very large trades easy.
4. Improved market efficiency. Low costs, leverage, liquidity and easy shorting make it cheaper to exploit mispricing, which pushes prices toward fair value.

Risks

Leverage appears on both lists. The small cash requirement behind the greater leverage and liquidity listed as benefits is also the source of the implicit leverage risk in the table below.

With margin equal to a fraction $m$ of contract value, a price change of $\Delta P\%$ changes the margin deposit by approximately

Margins of 3% to 12% imply leverage of roughly 33:1 to 8:1.

Futures carry three protections against counterparty risk: initial margin, daily mark-to-market, and the clearinghouse guarantee. Forwards may have none of these protections unless the contract provides for collateral or central clearing.

LOS 72.b — How issuers and investors use derivatives

Issuers (corporations)

Nonfinancial companies, called issuers in this context, use derivatives to manage the effect of prices, rates and currencies on asset and liability values and on earnings. Where allowed, hedge accounting lets a company recognize gains and losses on a qualifying hedge in the same period as the offsetting change in the hedged item. Hedges are classified by purpose:

The class depends on what is being hedged. Forward contracts appear in all three rows. An interest rate swap can fall in either of the first two, depending on the debt it hedges and which side of the swap the firm takes.

Investors

Investors use forward commitments and contingent claims to hedge, modify or increase exposure. For example, they can:

• buy commodity (e.g., silver) forwards to gain price exposure with little or no initial cash;
• lengthen a bond portfolio's duration by entering a swap as fixed-rate receiver and floating-rate payer, which is like issuing floating-rate debt to buy a fixed-rate bond;
• raise equity exposure temporarily by buying index futures, cut it by selling index futures, or protect the downside while keeping the upside by buying index puts.