Title LM01 Derivative Instrument and Derivative Market Features IFT Notes.pdf ✅

LM01 Derivative Instrument and Derivative Market Features 2025 Level I Notes © IFT. All rights reserved 1 LM01 Derivative Instrument and Derivative Market Features 1. Introduction ........................................................................................................................................................... 2 2. Derivative Features ............................................................................................................................................. 2 Definition and Features of a Derivative ..................................................................................................... 2 3. Derivative Underlyings ...................................................................................................................................... 4 Equities ................................................................................................................................................................... 4 Fixed-Income Instruments .............................................................................................................................. 4 Currencies .............................................................................................................................................................. 5 Commodities ......................................................................................................................................................... 5 Credit ....................................................................................................................................................................... 5 Other ........................................................................................................................................................................ 5 4. Derivative Markets .............................................................................................................................................. 5 Over-the-Counter (OTC) Derivative Markets .......................................................................................... 5 Exchange-Traded Derivative (ETD) Markets ........................................................................................... 6 Central Clearing ................................................................................................................................................... 7 Summary ...................................................................................................................................................................... 9 Required disclaimer: IFT is a CFA Institute Prep Provider. Only CFA Institute Prep Providers are permitted to make use of CFA Institute copyrighted materials which are the building blocks of the exam. We are also required to create / use updated materials every year and this is validated by CFA Institute. Our products and services substantially cover the relevant curriculum and exam and this is validated by CFA Institute. In our advertising, any statement about the numbers of questions in our products and services relates to unique, original, proprietary questions. CFA Institute Prep Providers are forbidden from including CFA Institute official mock exam questions or any questions other than the end of reading questions within their products and services. CFA Institute does not endorse, promote, review or warrant the accuracy or quality of the product and services offered by IFT. CFA Institute®, CFA® and “Chartered Financial Analyst®” are trademarks owned by CFA Institute. © Copyright CFA Institute Version 1.0
LM01 Derivative Instrument and Derivative Market Features 2025 Level I Notes © IFT. All rights reserved 2 1. Introduction Cash markets refers to markets in which financial assets like equities, fixed income securities, currencies and commodities are exchanged at current prices. Cash markets are also known as spot markets because the transactions are settled on the spot. In contrast, derivatives involve the future exchange of cash flows whose value is derived from or based on an underlying value. This learning module covers what is a derivative, the different types of derivatives, and the basic features of a derivatives market. 2. Derivative Features Definition and Features of a Derivative A derivative is a financial instrument that derives its value from the performance of an underlying asset. In simple terms, a derivative is a legal contract between a buyer and a seller, entered into today, regarding a transaction that will be fulfilled at a specified time in the future. This legal contract is based on an underlying asset. For example, exhibit 1 from the curriculum shows a ‘forward contract’ which is a type of derivative. In this example:  AMY Investments agrees today (t = 0) to deliver 1,000 shares of Airbus (AIR) at a fixed price of €30 per share on a future date (t = T), which in the example is six months.  The forward contract allows AMY to transfer the price risk of the underlying to the
LM01 Derivative Instrument and Derivative Market Features 2025 Level I Notes © IFT. All rights reserved 3 counterparty.  If the spot price of AIR is €25 after six months, AMY will still receive €30,000 from the counterparty in exchange for 1,000 AIR shares (which are now worth just €25,000). Alternatively, AMY could simply settle with the intermediary the €5,000 difference in cash. A derivative contract is a legal agreement between counterparties that defines the rights of each party involved. There are two parties participating in the contract: a buyer and a seller.  Long: Buyer of the derivative is said to be long on the position. He has the right to buy the underlying according to the conditions mentioned in the contract.  Short: Seller of the derivative is said to be short. Remember “s” is for short and seller. A stand-alone derivative is a distinct derivative contract such as a derivative on a stock or bond. In contrast, an embedded derivative is a derivative within an underlying, such as a callable, puttable, or convertible bond. Exhibit 2 from the curriculum provides a sample forward contract term sheet for the AMY example. Derivatives can be divided into two types: