Types of Financial Derivatives

Why This Matters

Financial derivatives are the backbone of modern risk management and speculation—and they're heavily tested because they reveal your understanding of time value of money, risk transfer, leverage, and market efficiency. When you encounter derivatives on an exam, you're not just being asked to define them. You're being tested on how these instruments shift risk between parties, how their pricing reflects market expectations, and why certain structures amplify or mitigate systemic risk.

The 2008 financial crisis made derivatives a permanent fixture in finance curricula, so expect questions connecting specific instruments to counterparty risk, leverage effects, and market liquidity. Don't just memorize what each derivative does—know why it exists, who uses it, and what happens when things go wrong. That conceptual understanding is what separates a passing answer from a top score.

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Exchange-Traded vs. Over-the-Counter Contracts

The first distinction you need to master is where a derivative trades. Exchange-traded derivatives offer standardization and reduced counterparty risk through clearinghouses, while OTC derivatives provide customization but expose parties to default risk.

Forwards

• Customized OTC contracts to buy or sell an asset at a specified future date and price—no standardization means terms are negotiated directly between parties
• Counterparty risk is significant because no clearinghouse guarantees performance; if one party defaults, the other absorbs the loss
• Primary use is hedging against price fluctuations in commodities, currencies, and interest rates—think of a wheat farmer locking in prices before harvest

Futures

• Standardized exchange-traded contracts with predetermined prices and settlement dates—the exchange specifies contract size, delivery dates, and quality standards
• Margin requirements and daily mark-to-market settlement dramatically reduce counterparty risk compared to forwards
• Used for both hedging and speculation across commodities, currencies, and indices; the S&P 500 futures are among the most liquid contracts globally

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Rights-Based Derivatives

Options differ fundamentally from forwards and futures because they create asymmetric payoffs. The holder has a choice, not an obligation—and that optionality has measurable value.

Options

• Grants the right, not obligation, to buy (call) or sell (put) an asset at a strike price before expiration—the asymmetry means losses are capped at the premium paid
• Leverage with limited downside makes options attractive for speculation; you control a large position with a small premium investment
• Pricing depends on five key factors: underlying asset price, strike price, time to expiration, volatility, and risk-free interest rate—this is the foundation of the Black-Scholes model

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Cash Flow Exchange Agreements

Swaps allow parties to exchange cash flows based on different underlying variables. They're the workhorses of corporate treasury departments, transforming one type of exposure into another without buying or selling the underlying assets.

Swaps

• Bilateral agreements to exchange cash flows based on notional principal—no principal actually changes hands, only the net difference in payments
• Interest rate swaps (fixed-for-floating) and currency swaps are the most common types, used to manage rate exposure or hedge foreign operations
• OTC trading creates counterparty risk, though netting agreements and central clearing (post-2008 reforms) help mitigate exposure

Credit Default Swaps (CDS)

• Transfers credit risk from one party to another—the buyer pays periodic premiums, and the seller compensates if a specified credit event (default) occurs
• Functions like insurance on bonds or loans, but buyers don't need to own the underlying debt—this creates speculative possibilities
• Played a central role in the 2008 crisis when AIG couldn't meet its CDS obligations; now subject to increased regulatory oversight

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Structured Products and Securitization

These derivatives pool underlying assets and redistribute risk through tranching—creating securities with different risk-return profiles from the same asset pool. Understanding securitization is essential for grasping how risk concentrates in financial systems.

Collateralized Debt Obligations (CDOs)

• Pool various debt instruments (loans, bonds, mortgages) and slice them into tranches ranked by seniority—senior tranches get paid first, equity tranches absorb first losses
• Higher-risk tranches offer higher yields to compensate for greater default exposure; ratings agencies assign grades to each tranche
• Criticized for 2008 crisis role due to complexity, opacity, and over-reliance on flawed credit ratings—exam questions often connect CDOs to systemic risk

Mortgage-Backed Securities (MBS)

• Securities backed by mortgage pools where investors receive payments from borrowers' principal and interest—prepayment risk is a key concern when rates fall
• Two main structures: pass-through securities (proportional share of all payments) and CMOs (tranched by maturity and risk)
• Provide liquidity to housing markets by allowing banks to sell mortgages rather than hold them—this "originate-to-distribute" model has both benefits and risks

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Quick Reference Table

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Self-Check Questions

1. Which two derivatives both lock in future prices but differ in their counterparty risk exposure? Explain what creates that difference.

2. A corporate treasurer wants to convert floating-rate debt to fixed-rate without refinancing. Which derivative accomplishes this, and how does the cash flow exchange work?

3. Compare and contrast CDOs and MBS: What do they share structurally, and how do their underlying asset pools differ?

4. If an investor wants leveraged exposure to stock price movements but needs to cap potential losses, which derivative type should they use? Explain why the payoff structure achieves this goal.

5. An FRQ asks you to explain how CDS contributed to systemic risk in 2008. What three key features of CDS would you discuss in your response?