Derivatives Fundamentals and Market Structure
Core concepts
A derivative is a contract whose value derives from an underlying reference (equity, index, rate, currency, commodity, credit event). Candidates must distinguish exchange-traded from OTC products: exchanges interpose a central counterparty (CCP), standardise terms, and publish prices, while OTC contracts are bilaterally negotiated and carry counterparty exposure unless cleared. Know the main families - forwards, futures, options, swaps - and the distinction between linear payoffs (forwards, futures, swaps) and non-linear payoffs (options). Understand the economic functions: hedging, speculation, arbitrage, and price discovery, plus the roles of market makers, brokers, and clearing members.
Traps
Questions often blur forward and future (a forward is OTC, customised, settled at maturity; a future is standardised, margined daily, and usually closed out). Another trap is confusing notional with market value - notional is the reference amount, not the exposure. Watch for 'zero-sum' framing: derivatives redistribute risk but can create net economic value through risk transfer and price discovery.
Worked rule of thumb
For a linear contract, profit to the long = (exit price − entry price) × contract multiplier × number of contracts. If a trader buys 5 index futures at 4,000 with a multiplier of 10 and exits at 4,050, profit = 50 × 10 × 5 = 2,500 units of quote currency. Always confirm the multiplier before computing.
Structure cues
Remember the chain: client → broker → clearing member → CCP. Each link adds obligations (margin calls, give-ups, default fund contributions) that appear in later domains.