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Set out what derivatives offer users and the risks they carry

CFA® Level I · Derivatives · Derivative Benefits, Risks, and Issuer and Investor Uses · DE.7.a

The idea

Derivatives allow risk to be transferred to whoever is best placed to bear it, at far lower transaction cost than trading the underlying, and they let exposure be taken where the cash market is impractical. They also aid price discovery, since the derivative market often trades when the underlying does not. The risks follow from the same features: the implicit leverage means small margin supports large exposure, basis risk means an imperfect hedge can move against the position it was meant to protect, and opacity in bilateral markets hides the build-up of exposure.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which is a recognised benefit of derivative markets?

  1. They eliminate market risk from the financial systemWhy not: Risk is transferred between participants, not destroyed. Someone always ends up holding it.
  2. They guarantee positive returns to hedgersWhy not: A hedge fixes an outcome; it does not promise a good one, and it often costs money when the feared event does not occur.
  3. They allow risk to be transferred at lower transaction cost than trading the underlying — correct

Risk transfer and cost efficiency are the core economic justification. Derivatives reallocate risk; they do not remove it.

A harder one

What is basis risk?

  1. That the hedge and exposure may diverge — correct
  2. The risk that a counterparty defaultsWhy not: Credit risk, addressed by clearing and collateral rather than by matching the hedge to the exposure.
  3. The risk that margin requirements changeWhy not: A liquidity and funding consideration, distinct from whether the hedge tracks what it is hedging.

The two do not move together perfectly. A hedge built on a related but not identical underlying, or a different maturity, leaves a residual that can move either way, which is the usual price of using a liquid standardised contract.

The hardest tier

Why are the benefits and the risks of derivatives described as following from the same features?

  1. Because both are regulated identicallyWhy not: Regulation is a response to the features rather than the reason they cut both ways.
  2. Because they are one property, two sides — correct
  3. Because both depend on the clearing houseWhy not: Clearing addresses credit risk and has nothing to do with why cheap exposure is double-edged.

Low cost and high exposure per unit of capital are the same feature seen twice. There is no version of the instrument that has the efficiency without the leverage.

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