Glossary — M03: Derivative Benefits, Risks, and Uses
Term
Definition
Risk transfer
The primary benefit of derivatives: shifting unwanted risk from hedgers to speculators or other parties willing to bear it
Price discovery
The process by which derivative markets reveal information about expected future prices and volatility
Operational advantage
Benefits of derivatives including lower transaction costs, greater liquidity, ease of short-selling, and implicit leverage
Leverage
The ability to control a large notional exposure with a small capital outlay; amplifies both gains and losses
Basis risk
The risk that the hedging instrument’s price movement does not perfectly offset the hedged item, arising from mismatches in underlying, maturity, or quantity
Basis
The difference between the spot price and the futures price: Basis=S−f
Liquidity risk
The risk that a derivative position cannot be closed or unwound quickly at a fair price
Counterparty risk
The risk that the other party to an OTC derivative defaults on its obligations
Systemic risk
The risk that failure of a major derivative market participant cascades through the financial system due to interconnected obligations
Hedge accounting
Accounting treatment (IFRS 9 / ASC 815) that aligns the recognition of gains/losses on hedging instruments with the hedged item
Cash flow hedge
A hedge of the variability of future cash flows; effective portion recorded in OCI until the hedged item affects earnings
Fair value hedge
A hedge of changes in the fair value of a recognized asset or liability; gain/loss on the hedge and hedged item both recognized in P&L immediately