Level 1 CFA® Exam:
Benefits & Risks of Derivatives
Since we are discussing derivatives, we have to mention the benefits and risks involved in these instruments. We can distinguish several types of benefits. Derivatives:
- provide information about the price of their underlying assets (aka. price discovery),
- are helpful in managing risk (risk allocation, transfer, and management).
- affect the efficiency of markets.
- reduce transaction costs.
What does it actually mean that derivatives provide investors with information about the price? The underlying assets for derivatives are the assets traded on dispersed markets. The problem with such assets is that investors may be unsure how to value them. This is when derivatives come in handy. Knowing the prices of futures for underlying assets, we can determine their actual price. Furthermore, derivative prices are a good reflection of investors' expectations about future asset prices.
When it comes to risk management, remember that derivatives are generally used for 3 types of transactions:
- hedging,
- speculation, and
- arbitrage.
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Derivatives are usually criticized for their construction. Because they are complex instruments, many investors don’t understand how they work, and the exposure profile when using different derivative instruments can be hard to grasp (lack of transparency).
Another reason why derivatives are criticized is the risk they involve. Because of the high level of leverage, some say that derivatives are a gamble. But what is leverage? Let’s take a simple example: suppose that a financial instrument costs USD 100 but the stock exchange tells the investor that in order to purchase it they have to invest only USD 10 (so 10% of the total amount). Now, if the price of the instrument increases by 1% (i.e. USD 1 in our example), so from USD 100 to USD 101, the value will also increase by USD 1 in the account, (from USD 10 to USD 11). However, we can see that the account balance has increased by 10%. Because of the leverage, the 1% increase in price has given the investor a 10% profit. This kind of increase is satisfying but there’s also the other side of the coin: if the price decreases by 1%, it translates into a 10% loss for the investor. Of course, such gains or losses apply only to 10:1 leverage but if the leverage was 50:1 or 100:1, the situation would be much worse.
Other types of risks are:
- basis risk - when a price of a derivative diverges from the price implied from the underlying asset,
- liquidity risk which occurs, e.g. when an investor receives a margin call in the case of a future contract and is not able to meet it,
- counterparty credit risk, especially in the case of the OTC derivatives, and
- systemic risk which may be a result of highly leveraged positions of market participants.
- Derivatives have their benefits because they: (1) provide information about the price of their underlying assets (aka. price discovery), (2) are helpful in managing risk, (3) affect the efficiency of markets, and (4) reduce transaction costs.
- Derivatives are usually criticized for: (1) their construction and (2) the risk they involve (because of the high level of leverage, some say that derivatives are a gamble).
- Other risks of derivatives are basis risk, liquidity risk, counterparty credit risk, and systemic risk.
- To sum up, despite the many benefits of derivatives, which include risk management and price discovery, you cannot forget about the complexity of these instruments and the risk created by using leverage.