Library/CFA (Chartered Financial Analyst)/Derivatives (CFA Program Curriculum 2026 • Level I • Volume 7)/Learning Module 1 Derivative Instrument and Derivative Market Features

Learning Module 1 Derivative Instrument and Derivative Market Features

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Definitions, Underlyings, and Instrument Types5 min

A derivative is a financial contract whose value is derived from an underlying asset or variable. Underlyings include equities (individual stocks, indexes, volatility), fixed-income and interest rates (sovereign bonds, market reference rates), currencies (exchange rates), commodities (soft and hard), credit (single-name or index credit risk), and other underlyings (weather, longevity, cryptocurrencies). Derivatives can be stand-alone contracts or embedded within other securities. Two broad instrument types are firm commitments (forwards, futures, swaps) which obligate counterparties to exchange cash or assets at future dates, and contingent claims (options, credit default swaps in structure) where one party has the right but not the obligation to transact. Forward contracts are flexible OTC agreements with a fixed forward price agreed at inception and settlement at maturity equal to ST minus F0(T) from the buyer's perspective. Futures are standardized, exchange-traded versions of forward commitments that are marked to market daily via margin accounts; initial margin and maintenance margin reduce bilateral credit risk and create variation margin flows. Swaps are series of forward-like exchanges (commonly fixed-for-floating interest payments) netted each period with no notional exchange. Options (calls and puts) are contingent claims: the buyer pays a premium for the right to exercise at an exercise price X at or before maturity depending on option style; payoffs are max(0, ST − X) for a call and max(0, X − ST) for a put, and profits incorporate the premium. Credit derivatives (CDS) transfer default risk: a protection buyer pays a spread and receives contingent payment equal to loss given default upon a credit event; MTM of CDS reflects spread changes and effective duration.

Key Points

Derivative value is derived from an underlying asset or variable.
Main underlyings: equities, interest rates, currencies, commodities, credit, others.
Firm commitments (forwards, futures, swaps) are linear; contingent claims (options) are non-linear.
Futures are exchange-traded with daily MTM and margin; forwards are OTC and settled at maturity.
Swaps exchange series of cash flows; CDS transfer credit risk.

Markets, Clearing, Benefits, and Risks5 min

Derivative markets include over-the-counter (OTC) markets and exchange-traded derivative (ETD) markets. OTC markets allow customization between end users and dealers but have greater counterparty and transparency risks. ETD markets provide standardization, liquidity, price discovery, and central clearing via clearinghouses. Central counterparties (CCPs) novate trades and assume counterparty risk between dealers, reducing bilateral exposures but concentrating systemic risk. Benefits of derivative use include efficient risk transfer and management, reduced upfront cash requirements, shorting, operational advantages (avoiding physical delivery costs), and price discovery. Risks include high implicit leverage, lack of transparency, basis risk, liquidity risk (margin calls), counterparty credit risk, and systemic risk from interconnectedness and concentration. Issuers commonly use derivatives to hedge exposures affecting assets, liabilities, and earnings, and pursue hedge accounting treatment (cash flow, fair value, net investment) when possible. Investors use derivatives to replicate exposures, change portfolio risk profiles, gain leverage, and implement tactical views. Structured notes embed derivatives and carry issuer credit risk, liquidity, and transparency considerations.

Key Points

OTC offers customization; ETD offers standardization and transparency.
CCPs reduce bilateral credit risk but concentrate systemic risk.
Derivatives provide operational advantages and price discovery.
Key risks: leverage, basis, liquidity, counterparty credit, systemic risk.
Issuer hedges vs investor replication differ; hedge accounting matters for issuers.

Arbitrage, Replication, Cost of Carry, and Forward Pricing6 min

Arbitrage forbids riskless profit: identical cash flows must have the same price and assets with known future prices must discount to current spot prices at the risk-free rate. Replication constructs a forward payoff via spot positions and borrowing/lending at the risk-free rate, demonstrating no-arbitrage relationships. For an asset with no income or storage costs, the forward price F0(T) equals S0(1 + r)^T (discrete) or S0 e^{rT} (continuous). When an asset has incomes (dividends, coupons, foreign interest) or costs (storage, insurance), forward prices are adjusted: F0(T) = [S0 − PV(I) + PV(C)](1 + r)^T or F0(T) = S0 e^{(r + c − i)T} under continuous rates. FX forwards incorporate interest rate differentials: F0,f/d(T) = S0,f/d e^{(r_f − r_d)T}. The mark-to-market value of an existing forward at time t is Vt(T) = St − PVt[F0(T)], adjusted for remaining PV of incomes or costs on the underlying. Zero rates and discount factors are derived from coupon bond prices to obtain spot rates and implied forward rates used in FRA and swap pricing.

Key Points

No-arbitrage links spot and forward via the risk-free rate and costs/benefits.
Replication: forward = buy spot + borrow at risk-free rate (or converse).
Cost of carry = opportunity cost + storage cost − income (dividends/coupons).
FX forwards determined by interest rate differential between currencies.
Zero rates and implied forward rates are derived from market bond prices and underpin FRA and swap pricing.

Questions

Question 1

Which definition best describes a derivative instrument?

Learning Module 1 Derivative Instrument and Derivative Market Features

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