9.1 Derivative Markets, Forward Commitments, and Claims
Key Takeaways
- A derivative is a contract whose value is derived from an underlying asset, rate, index, event, or other variable.
- Forward commitments create obligations for both sides, while contingent claims create asymmetric rights and obligations.
- Exchange-traded derivatives reduce counterparty and liquidity risk through standardization and clearing, while OTC contracts allow customization.
- Derivative value changes through exposure to the underlying, time, volatility, interest rates, credit risk, and contract terms.
- Level I questions often test the economic position created by a derivative rather than legal detail.
What a derivative is
A derivative is a financial contract whose value depends on something else. The underlying can be a stock, bond, interest rate, currency, commodity, credit event, weather measure, or index. The derivative is useful because it lets market participants transfer or reshape risk without always trading the underlying asset directly.
For CFA Level I, the central question is exposure. A derivative can create upside, downside, leverage, protection, or a fixed future transaction price. The contract matters because two positions with the same underlying can have very different payoffs, cash flows, credit exposure, and liquidity.
Derivatives appear in Session 2 and are a smaller topic by exam weight, but they connect to fixed income, equities, alternatives, currencies, and portfolio management. A bond manager may use interest rate futures. An importer may use currency forwards. An equity investor may use options. A bank may use swaps to change interest rate exposure.
Forward commitments versus contingent claims
A forward commitment obligates each party to transact or exchange cash flows in the future. The long side generally benefits when the underlying price rises. The short side generally benefits when the underlying price falls. Forwards, futures, and swaps are forward commitments.
A contingent claim gives one side a right linked to a future event or price. The payoff depends on whether the contingency occurs. Options are the main Level I example. The option buyer has a right, while the option seller has an obligation if the buyer exercises.
| Contract type | Buyer position | Seller position | Typical payoff shape |
|---|---|---|---|
| Forward | Obligation to buy later | Obligation to sell later | Symmetric gain or loss |
| Futures | Standardized obligation | Standardized obligation | Symmetric gain or loss with daily settlement |
| Swap | Exchange cash flows | Exchange cash flows | Net cash flow exposure |
| Call option | Right to buy | Obligation to sell | Upside with limited premium loss |
| Put option | Right to sell | Obligation to buy | Downside protection or bearish exposure |
Exchange-traded and OTC markets
Exchange-traded derivatives are standardized contracts traded on organized exchanges. Contract size, expiration, quality grade, settlement rules, and trading procedures are set by the exchange. Standardization supports liquidity and price transparency. Clearinghouses reduce counterparty risk by standing between buyers and sellers.
OTC derivatives are negotiated directly between parties. They can be customized for exact maturity, notional amount, underlying, settlement currency, and payoff terms. Customization is valuable, but it can increase counterparty risk, model risk, documentation complexity, and liquidity risk.
A cleared exchange-traded futures contract is usually easier to close before maturity than a customized OTC forward. A customized OTC currency forward may fit a firm's exact invoice date better than a listed futures contract. The exam often asks candidates to identify that trade-off.
Price, value, and exposure
The price of a derivative is the agreed contract term, such as a forward price or option premium. The value is what the existing contract is worth today. At initiation, many forward commitments have a value near zero because the contract price is set to make neither side pay upfront, ignoring costs and credit effects.
After initiation, value changes as the underlying, interest rates, dividends, storage costs, convenience yield, volatility, time to expiration, and credit conditions change. A long forward entered at 100 becomes valuable if the market forward price rises to 108. The right to buy at 100 is more attractive when the underlying can be sold or valued near 108.
Structured aid: classify the contract
- Identify the underlying variable.
- Ask whether both sides have obligations or one side has a right.
- If both sides are obligated, classify the contract as a forward commitment.
- If one side has a right and the other an obligation, classify it as a contingent claim.
- Identify where it trades: exchange, cleared OTC, or bilateral OTC.
- Link the classification to payoff shape, liquidity, and counterparty risk.
Exam focus
Read the position first. Long means the position benefits from the economic exposure described by the contract, not always from owning the underlying today. A long forward benefits from a higher underlying price at expiration. A long put benefits from a lower underlying price because the right to sell becomes more valuable.
Then read the market structure. Standardized exchange trading points toward liquidity, transparency, margin, and clearing. Custom OTC trading points toward tailored terms and higher bilateral credit or liquidity concerns. Most Level I derivative questions can be answered by mapping the contract to obligation, payoff, and risk transfer.
A derivative contract in which both parties are obligated to transact in the future is best described as:
Compared with an exchange-traded derivative, an OTC derivative is most likely to offer:
A long put option most likely gives its holder the right to: