Chapter 6: Derivative Benefits, Risks, and Uses

In this section

• Risk Management and Hedging
  Comprehensive exploration of derivatives in risk management and hedging, including instruments, strategies, and examples for both seasoned learners and beginners.
• Speculation and Leverage
  Explore how derivatives enable speculative trading, the mechanics of using leverage, critical risk management considerations, and how prudent speculation can enhance overall market liquidity and efficiency.
• Derivative-Related Risks
  Explore the various risks inherent in derivative instruments, including market risk, counterparty credit risk, liquidity risk, funding risk, operational risk, legal risk, and model risk, and learn best practices for managing these exposures in a multi-asset portfolio.
• Counterparty Risk in OTC Markets
  Explore the nuances of bilateral credit exposure in OTC derivatives markets, including netting agreements, wrong-way risk, and best practices for mitigating default risk.
• Uses of Derivatives by Issuers and Investors
  An in-depth exploration of how different market participants—including corporate issuers, institutional investors, and insurance companies—utilize derivatives to manage risks, engineer custom exposures, and enhance returns.
• Operational, Legal, and Liquidity Risks
  Explore core operational, legal, and liquidity risks faced by derivatives market participants, including settlement failures, contract enforceability, and liquidity constraints during market stress.
• Regulatory Considerations for Risk Management
  An in-depth exploration of how post-crisis regulations like Dodd-Frank, EMIR, and MiFID II shape derivative risk management, focusing on mandatory clearing, position limits, reporting obligations, cross-border challenges, and enforcement actions.
• Tax Implications of Derivative Transactions
  Learn how gains and losses on derivatives are taxed, including capital vs. ordinary income distinctions, the 60/40 rule, wash sale regulations, cross-border considerations, and constructive sales.
• Collateralization and Funding Costs
  Explore how collateral and funding costs shape derivative transactions, including initial vs. variation margin, rehypothecation, and optimization strategies.
• ESG Considerations and Sustainability Risk Hedging
  Discover the essentials of ESG-linked derivatives, including green swaps, carbon allowances, and climate risk hedging, and learn how to integrate sustainability principles into modern derivative strategies.
• Case Studies of Derivative Disasters
  Explore major derivative blowups—Barings, LTCM, Société Générale, and Metallgesellschaft—examining how risky strategies, unauthorized trading, and inadequate controls led to catastrophic outcomes.
• Hedge Accounting Considerations
  Explore the core principles, real-world applications, and testing methods of hedge accounting under IFRS 9 and ASC 815, focusing on fair value, cash flow, and net investment hedges.
• Reporting and Disclosure of Derivative Positions
  Explore how firms report and disclose derivative holdings, including financial statement footnotes, regulatory filings, fair value hierarchy classifications, and risk metrics such as VaR.
• Internal Controls for Derivative Operations
  Discover how robust internal controls in derivative operations safeguard organizations from unfettered risk, conflicts of interest, and accounting errors.
• Cybersecurity Risks in Derivative Markets
  Explore how hacking, phishing, and technological vulnerabilities can disrupt derivative markets, and learn best practices to protect data and trading infrastructures.
• Role of Third-Party Custodians in Collateral Management
  An in-depth exploration of how third-party custodians help reduce settlement risk, streamline tri-party repo arrangements, and ensure collateral eligibility in derivatives markets.
• Uncleared Margin Requirements for OTC Derivatives
  Learn how regulators introduced and implemented margin rules for non-centrally cleared derivative transactions, including operational challenges, SIMM methodology, and best practices for risk mitigation.
• Post-Trade Processing, Settlement, and Collateral Optimization
  Explore the intricate processes and tools involved in post-trade workflows, focusing on affirmation, settlement, collateral optimization, and best practices in automation.
• Risk Parity Strategies and Derivatives
  Explore how leveraging low-volatility assets with derivatives can balance your portfolio’s risk contributions, along with real-world examples, potential pitfalls, and best practices.
• Combinations and Overlays in Portfolio Management
  Learn how overlay strategies, duration overlays, currency overlays, and portable alpha can dynamically reshape portfolio exposures and enhance returns.
• Real-Time Risk Management and Intraday Margin Calls
  A detailed exploration of real-time risk controls, automated intraday margin processes, and dynamic hedging strategies in volatile derivative markets.
• Cross-Asset Volatility and Correlation Trading
  Explore key techniques for managing and profiting from volatility and correlation across multiple asset classes, leveraging derivatives such as variance swaps, VIX futures, and correlation swaps.