Derivatives Overview

This is a brief overview of derivatives to follow the CFA curriculum sequence, as there is an entire chapter dedicated to this topic. Key terms include clearinghouse, initial margin, maintenance margin, and variation margin.

Clearinghouse

The clearinghouse acts as an intermediary that guarantees trades are settled properly, thereby reducing counterparty risk. This is why exchange-traded derivatives carry less risk than over-the-counter (OTC) markets.

Margins

• Initial margin: upfront collateral required to open a leveraged position.
• Maintenance margin: minimum capital that must remain in the account before a margin call or forced liquidation.
• Variation margin: daily gain or loss adjustments specific to futures contracts (mark-to-market).

Comparison of Derivative Types

Category	Right or Obligation	Standardization	Trading Environment	Counterparty Risk
Options	Right, not obligation	Standardized	Exchange	Low (due to clearinghouse)
Futures	Obligation	Standardized	Exchange	Low (due to clearinghouse)
Forwards	Obligation	Customized	OTC	High
Swaps	Obligation	Customized	OTC	High

Credit Default Swaps (CDS)

A Credit Default Swap (CDS) is a swap used to transfer credit risk. The buyer pays premiums to the seller, functioning like insurance. If a credit event (default) occurs, the buyer stops paying and receives compensation equivalent to the CDS’s notional value.

For instance, buying a CDS on a company’s bond protects against default. The CDS buyer receives the bond’s principal amount if the issuer defaults, just like an insurance payout after an accident.

Example: The Big Short

The film The Big Short illustrates how CDS contracts work. Investor Michael Burry purchases CDSs on mortgage-backed securities (MBS) and CDOs to bet against the U.S. housing market. In the movie, he states: “I want to buy swaps on mortgage bonds that will pay off if the underlying bonds fail.”

By doing this, Burry takes a contrarian position. When the housing bubble burst and the MBS and CDO markets collapsed, his CDS contracts paid out the difference between their original principal value and their post-crisis near-zero value. This resulted in massive profits due to his leveraged exposure.