Derivatives fundamentals and market structure
What this domain covers
This section tests classification and market structure: how forwards, futures, options and swaps differ by payoff, how exchange-traded and OTC markets operate, and why hedgers, speculators and arbitrageurs use derivatives. Questions often ask you to identify a payoff, calculate a hedge ratio, or explain the role of a central counterparty (CCP).
Core rules and concepts
- A derivative is a contract whose value depends on an underlying asset, rate, index or credit event. The notional is the reference amount; market value is what the contract is worth today.
- Forwards and futures have linear payoffs; options have non-linear, asymmetric payoffs; swaps can be decomposed into a series of forwards.
- Exchange-traded contracts are standardised, CCP-cleared and marked to market daily. OTC contracts are bespoke, documented under an ISDA Master Agreement, and carry bilateral counterparty risk unless cleared.
- Hedgers transfer price risk; speculators accept it for expected return; arbitrageurs trade mispricing between cash and derivative or between venues.
- A CCP interposes itself between buyer and seller, nets exposures, and collects initial and variation margin.
Worked example
A £10m equity portfolio has beta 1.2. The manager wants beta 0.8 using FTSE 100 futures at 7,500 with a £10 multiplier, so one contract is worth £75,000. Number of contracts = ((target beta − current beta) × portfolio value) ÷ futures contract value = ((0.8 − 1.2) × £10m) ÷ £75,000 = −53.3. Sell 53 contracts. The hedge reduces equity exposure by 0.4 × £10m = £4m; 53 × £75,000 = £3.975m, leaving beta about 0.802. Rounding and basis risk mean the hedge is not exact.
Traps that cost marks
- Treating the notional as the cash cost: futures require margin, not the full contract value.
- Mixing portfolio beta with index beta, or forgetting the contract multiplier.
- Assuming OTC means unregulated; many OTC derivatives are subject to clearing and reporting.
- Ignoring basis risk, rounding and daily margining when evaluating a hedge.