7.1 Derivatives: Role, Underlying Assets & Users

Canadian Securities Course CSC

Track your progress as you read

Finished sections get a check mark.

1 Introduction & Exam Overview

About the CSC Exams

2 Chapter 1: The Canadian Investment Marketplace

1.1 The Canadian Securities Industry & the Investment Dealer's Role 1.2 Financial Intermediaries: Banks, Trusts, Credit Unions, Insurers & Pension Funds 1.3 Financial Market Trends 1.4 Investment Capital, Financial Instruments & Financial Markets 1.5 Canadian Exchanges, ATSs, Dark Pools & the Order Protection Rule 1.6 Canadian Securities Regulators, the CSA & CIRO 1.7 Investor Protection: OSFI, CIPF and CDIC 1.8 Ethics, Standards of Conduct & the Client Focused Reforms 1.9 Conflicts of Interest, Complaint Handling & Remediation

3 Chapter 2: The Economy

2.1 Economics Foundations & Measuring Economic Growth 2.2 The Business Cycle & Economic Indicators 2.3 Inflation & Interest Rates 2.4 The Labour Market & Unemployment 2.5 The Bank of Canada & the Inflation-Control Target 2.6 Implementing Monetary Policy: The Operating Band, Market Operations & Transmission 2.7 Fiscal Policy, Deficits & the Challenges of Government Policy 2.8 International Finance & Trade: The Balance of Payments and the Canadian Dollar

4 Chapter 3: Features and Types of Fixed-Income Securities

3.1 The Fixed-Income Marketplace, Bond Terminology & Security 3.2 Protective Covenants, Retirement Provisions & Extendible/Retractable Features 3.3 Government of Canada Securities: T-Bills, Marketable Bonds & RRBs 3.4 Provincial & Municipal Debt and Strip Bonds 3.5 Corporate Bonds, Credit Spreads & Bond Ratings 3.6 Money Market Instruments, Floating-Rate Notes & International Bonds 3.7 Other Fixed-Income Securities & Reading Bond Quotes

5 Chapter 4: Pricing and Trading of Fixed-Income Securities

4.1 Bond Pricing, Price–Yield Relationships & Accrued Interest 4.2 Yield Calculations & Return Measures 4.3 The Term Structure of Interest Rates & Yield Curve Theories 4.4 Fundamental Bond Pricing Properties: Volatility Rules, Duration & Convexity 4.5 Bond Market Trading & Bond Indexes

6 Chapter 5: Common and Preferred Shares

5.1 Common Shares: Ownership Rights, Voting & Restricted Shares 5.2 Dividends, DRIPs, Stock Splits & Consolidations 5.3 Preferred Shares: Features, Cumulative Dividends & Taxation 5.4 Preferred Share Variations: Convertible, Callable, Retractable, Floating & Rate-Reset 5.5 Fundamental Equity Metrics & Ratios 5.6 Stock Indexes & Averages

7 Chapter 6: Equity Transactions

6.1 Order Types, Execution & Market Mechanics 6.2 Margin Trading: Long Accounts & Borrowing 6.3 Short Selling & Short-Margin Requirements 6.4 Trading & Settlement Procedures: T+1, CDS & Confirmations

8 Chapter 7: Derivatives

7.1 Derivatives: Role, Underlying Assets & Users 7.2 Options Fundamentals: Calls, Puts & Moneyness 7.3 Option Strategies & Risk Management 7.4 Forward & Futures Contracts 7.5 Rights & Warrants

9 Chapter 8: Corporations and their Financial Statements

8.1 Corporate Structures & Corporate Governance 8.2 The Annual Report, Accounting Standards & the Auditor's Report 8.3 The Balance Sheet & Income Statement 8.4 The Cash Flow Statement & Earnings Quality 8.5 Public Company Disclosure, Investor Rights, Take-Over Bids & Insider Trading

10 Chapter 9: Financing and Listing Securities

9.1 Government & Corporate Financing: Underwriting and Syndicates 9.2 The Prospectus Process, Stabilization & Purchaser Rights 9.3 The Exempt Market & Private Placements 9.4 The Listing Process: TSX, TSXV & Capital Pool Companies 9.5 Continuous Disclosure, Material Changes & Insider Reporting

11 Chapter 10: Investment Analysis

10.1 Methods of Equity Analysis & Macroeconomic Analysis 10.2 Fundamental Industry Analysis 10.3 Company Analysis: Competitive Advantages, Governance & the Dividend Discount Model 10.4 Discounted Cash Flow & Relative Valuation Multiples 10.5 Financial Statement Ratio Analysis 10.6 Assessing Preferred Share Investment Quality 10.7 Technical Analysis: Charts, Trends & Patterns 10.8 Technical Indicators, Volume, Breadth & Sentiment

12 Chapter 11: Portfolio Analysis

11.1 Measuring Investment Return 11.2 Measuring Risk: Types of Risk, Standard Deviation & Downside Measures 11.3 Portfolio Risk & Return: Correlation and Diversification 11.4 Beta, the Capital Asset Pricing Model & the Security Market Line 11.5 Portfolio Manager Styles: Equity & Fixed Income 11.6 The Portfolio Management Process: Objectives, Constraints & the IPS 11.7 Asset Mix, Monitoring, Performance Evaluation & Rebalancing

13 Chapter 12: Alternative Investments, Other Managed, and Structured Products

12.1 Alternative Investments: Structures, Fees & Liquid Alternatives 12.2 Alternative Strategies, Performance Measurement & Due Diligence 12.3 Segregated Funds, Labour-Sponsored Funds & Listed Private Equity 12.4 Income Trusts, REITs & Closed-End Funds 12.5 Structured Products: PPNs & Market-Linked GICs 12.6 Split Shares & Asset-Backed Securities

14 Chapter 13: Mutual Funds

13.1 Managed Products & Mutual Fund Structure 13.2 Pricing Mutual Fund Units: NAVPS & Forward Pricing 13.3 Mutual Fund Fees, Sales Charges & Unit Series 13.4 Mutual Fund Regulation, Fund Facts & Account Opening 13.5 Types of Mutual Funds & Fund Management Styles 13.6 Redemptions, Withdrawal Plans & Measuring Fund Performance

15 Chapter 14: Exchange-Traded Funds (ETFs)

14.1 ETF Origins, Structure, Tax Efficiency & ETF Facts 14.2 ETF Creation, Redemption & Arbitrage 14.3 Types of ETFs & Advanced Strategies 14.4 Comparing ETFs, Mutual Funds & Individual Securities

16 Chapter 15: Working with the Institutional Client

15.1 The Institutional Marketplace & Institutional Clients 15.2 Institutional Investment Guidelines, Styles & Restrictions 15.3 Buy Side & Sell Side: Trading Desks, Revenue, Clearing & Best Execution 15.4 Block Trading, Dark Pools & Algorithmic Trading

17 Chapter 16: Fee-Based Accounts and Working with the Retail Client

16.1 Fee-Based Accounts: Managed & Non-Managed Models 16.2 Fee Transparency, CRM2 & Total Cost Reporting, and MWRR vs. TWRR 16.3 The Financial Planning Approach & the Life Cycle 16.4 Behavioral Finance, Sequence-of-Returns Risk & Client Coaching 16.5 Estate Planning Basics

18 Chapter 17: Canadian Taxation

17.1 The Canadian Taxation System 17.2 Taxation of Investment Income 17.3 Capital Gains, Losses & The Superficial Loss Rule 17.4 Registered vs Non-Registered Tax-Advantaged Accounts 17.5 Tax Planning Strategies, Pension Plans & the RDSP

7.1 Derivatives: Role, Underlying Assets & Users

Key Takeaways Explain This Topic AI

A derivative's value depends on an underlying asset such as a stock, index, bond, interest rate, currency or commodity.

Exchange-traded derivatives are standardized and centrally cleared; over-the-counter derivatives are customized and carry counterparty risk unless cleared.

Hedgers use derivatives to reduce risk, speculators to profit from expected price moves, and arbitrageurs to exploit price differences.

Derivatives provide leverage, which magnifies both gains and losses.

In Canada, listed derivatives trade on the Montréal Exchange and clear through CDCC; many OTC derivatives must be reported to trade repositories, and some must be centrally cleared.

Last updated: October 2026

A derivative is a contract whose value is based on (derived from) the price of something else, called the underlying asset or underlying interest . The main types, options, forwards, futures, rights and warrants, are covered in the sections that follow. This section explains why derivatives exist and who uses them.

Types of Underlying Assets

• Category Examples of underlying assets Example derivatives
• Equities Individual shares, ETFs Equity options, rights, warrants
• Stock indexes S&P/TSX 60 Index futures (SXF) and index options

Interest rates and bonds CORRA, Government of Canada bonds CORRA futures, 10-year bond futures (CGB), interest rate swaps

• Currencies U.S. dollar, euro Currency forwards, futures and options
• Commodities Crude oil, natural gas, gold, wheat Commodity futures and options
• Credit A company's risk of default Credit default swaps
• Exchange-Traded vs. Over-the-Counter Derivatives

• Feature Exchange-traded Over-the-counter (OTC)
• Terms Standardized by the exchange Negotiated to suit the parties
• Trading On an exchange such as the Montréal Exchange Directly between the parties, often a bank and a client

Counterparty risk Removed by a clearinghouse (CDCC) Each party depends on the other, unless the trade is centrally cleared

• Transparency Public prices and volumes Private prices
• Liquidity Easy to close by an offsetting trade Harder to exit before maturity
• Examples Listed options, futures Forwards, swaps, many currency contracts
• The Users of Derivatives
• Hedgers

Hedgers already have a risk and use derivatives to reduce it.

A Canadian gold miner that will produce gold next year sells gold futures to lock in a price.

An exporter expecting U.S.-dollar revenue sells U.S. dollars forward to fix the exchange rate.

A portfolio manager worried about a short-term market drop sells S&P/TSX 60 futures or buys index puts instead of selling the stocks.

Hedging gives up some upside in exchange for protection. The miner that sold futures does not benefit if gold soars, but it is protected if gold collapses.

Speculators

Speculators take on risk in the hope of profit. Derivatives appeal to them because of leverage : a small premium or margin deposit controls a much larger position. Speculators add liquidity to derivatives markets and take the other side of hedgers' trades, but they can lose more than they expect, and in some positions (such as writing uncovered calls) more than they invest.

Arbitrageurs

Arbitrageurs look for price differences between related instruments, for example when a futures contract is priced out of line with its underlying index. They buy the cheaper instrument and sell the more expensive one, locking in a small profit. Their trading keeps derivative prices consistent with the underlying markets.

Worked Example: Hedging with Index Futures

A portfolio manager runs a $10 million portfolio of large Canadian stocks that moves closely with the S&P/TSX 60 Index. Expecting a short-term decline but not wanting to sell the stocks (which would trigger trading costs and capital gains), the manager sells S&P/TSX 60 futures with a total underlying value of about $10 million.

• Outcome Stock portfolio Short futures Net
• Index falls 5% −$500,000 +$500,000 about $0
• Index rises 5% +$500,000 −$500,000 about $0

The hedge locks in the portfolio's value for the life of the futures: the manager is protected if the market falls but gives up any gain if it rises. A hedge with index put options works differently: it costs a premium up front but keeps the upside. In practice no hedge is perfect, because the portfolio does not exactly match the index (basis risk) and the futures price reflects the cost of carry.

Why Derivatives Are Useful

Risk management: transferring unwanted price, rate or currency risk to someone willing to bear it.

Price discovery: futures prices reveal the market's expectations for future prices.

Lower transaction costs: changing a portfolio's exposure with one futures trade is cheaper than trading many stocks.

Flexibility: creating payoffs that are impossible with the underlying asset alone, such as protecting against a fall while keeping the upside.

The Risks

Leverage risk: small moves in the underlying asset cause large gains or losses.

Counterparty risk: in OTC contracts, the other party may default.

Liquidity risk: some contracts are hard to close before maturity.

Basis risk: a hedge may not move exactly with the asset being hedged.

Complexity: investors can misunderstand how a position behaves.

How Derivatives Are Regulated in Canada

Listed derivatives trade on the Montréal Exchange and clear through the Canadian Derivatives Clearing Corporation (CDCC) . After the 2008 financial crisis, Canadian regulators also brought OTC derivatives under oversight: many OTC trades must be reported to designated trade repositories , and certain standardized OTC derivatives between large market participants must be centrally cleared . Dealers must assess whether derivatives trading is suitable for each client, and individuals who trade or advise on derivatives must meet CIRO's proficiency requirements.