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CFA Level I · CFA Level I Exam · Derivative Benefits, Risks, and Issuer and Investor Uses

A trader buys a futures contract by posting a small initial margin. The underlying price then falls sharply and the trader must deposit additional funds immediately. This situation most likely illustrates which risk associated with derivatives?

The scenario best illustrates liquidity risk driven by leverage and daily settlement. A small margin controls a large exposure, so an adverse price move triggers a margin call requiring prompt cash, which can force the trader to liquidate positions or raise funds under pressure.

  1. ABasis risk arising from a mismatch between the hedge and the exposure
  2. BLiquidity risk arising from leverage and daily settlement of lossesCorrect
  3. CModel risk arising from an incorrect pricing assumption

Explanation

Futures are marked to market daily, and leveraged positions can produce losses far larger than the margin posted. The resulting margin call demands cash quickly, which is a liquidity (funding) risk. Nothing in the scenario involves a hedge mismatch or a flawed pricing model.

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