Derivatives liquidity

CFA Level III Derivatives
#1

In CFA curriculum, it says illquidity in spot market would pass on to derivatives, hence derivatives would not generate any liquidity. In risk mgmt, it claims that trading derivatives, especially futures and forwards, are more liquid than the underlying.

So, what’s the conclusion?

trading in derivatives will or will not introduce liquidity?

#2

I’m not sure I agree with the CFA’s statement regarding illiquidity in the underlying passing through to derivatives. The statement that derivatives are more liquid than the underlying in many cases is consistent with my experience. I would think of the liquidity in selling cattle versus selling cattle futures, for example.

I don’t know what CFA is thinking of in the first case, in all honesty so maybe someone can enlighten me as well?

#3

Illiquid positions would increase margin requirements what will affect the liquidity of the position holder. That’s on my mind although I’m not sure if that the point is.

#4

I was also thinking they were referring to options of illiquid securities passing through to the derivatives market. I think futures and forwards as mentioned are more liquid in a lot of markets. But if you have a stock that is illiquid, it’s going to be harder to find a dealer that is offering options on that stock. Good question though, I’m not totally sure and could be way off.

#5

I think there’s a key component to the statement that has been omitted. I’m fine to conclude that illiquid stocks likely don’t have liquid options (or even forwards!) on those stocks since delivery on the derivative would be expensive. That’s the interpretation that makes the most sense to me in this context without further information.

#6

Thanks mate. I think u are making a point.

#7

It is stated in volume 5, page 143 of print curriculum.

_ ”Although derives can be used to effectively sell an asset or liquidate a short position, they often will not help in managing liquidity risk. If the underlying is illiquid, there is a good possibility that the universe of associated derivative instruments may also be illiquid.” _