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CFA Level 1
. Unit 8: Derivatives
UOLLB CFA Top Notes
Level 1 Exam
Unit 8: Derivatives
Table of Contents
Types of Derivatives..........................................1
Forward Contracts.............................................1
Option Contracts...............................................2
Interest Rate Option..........................................3
Option Payoff Matrix........................................4
Effect of Interest Rates......................................5
Effect of Volatility.............................................5
Option Price Sensitivities..................................5
Swap Contracts..................................................5
Risk Management..............................................6
Risk Management Strategies.............................6
Types of Derivatives
Exchange Traded
Contracts with standards terms and features
No default risk
Over-the-Counter
Contracts with customized terms
Default risk
Forward
An over-the-counter (non-standardized)
contract between two parties to sell and buy a particular asset at a specified price and time
Callable Bond
A right for the issue to pay off the bond before its maturity
Asset-backed Security
Security with value and income payments derived from a specified pool of underlying assets (mortgages / loans / bonds)
Purposes of Derivative Markets
Price Discovery (underlying assets)
Risk Management (hedge)
Speculation
Enhancement of Market Efficiency
Future
A standardized (exchange traded) contract between two parties to sell and buy a particular asset at a specified price and time
Arbitrage
Attempt to make costless profits through exploiting price differences of an asset by buying at a lower price and immediately selling at a higher price in different markets.
Swap
Agreement between two parties to exchanges a series of future cash flows
Law of One Price
Situation in which no arbitrage opportunities are available
Contingent Claim
Derivative in which the payoff occurs if a specific event happens
Option
A right but not an obligation to buy / sell a given asset at a specified price during a specified period of time
Forward Contracts
Forward
An over-the-counter (non-standardized)
contract between two parties to sell and buy a particular asset at a specified price and time
Deliverable Forward 1 CFA Level 1
. Unit 8: Derivatives
The long will pay the agreed price to the short
The short in turn will deliver the underlying asset to the long
Non-Deliverable Forward (NDF)
Settled by Cash
Default Risk (Counterparty Risk)
Potential exists for a party to default
Termination of Forward Contract
Enter into an opposite contract with an expiration date equal to the remaining time of the original contract
New contract can be entered into with the counterparty by paying to him the difference between the original and new contracts
New contract can be entered into with a third party, but this will increase the counterparty risk in case the third-party default
End Users of Forward Contract
Corporation / Gov unit / Nonprofit institution that has existing risk they wish to avoid by locking in the future price of an asset
Dealers of Forward Contracts
Bank / Financial institution which enters a forward contract with an end user who has an opposite risk exposure
Dealer transfers his risk by entering an opposite forward contract to another end user who has an opposite view and make profit from the ask-bid spread
Types of Equity Forwards
Forward Contract on an Individual Stock
Forward Contract on Stock Portfolio (i.e. a group of stock)
Forward Contract on Stock Indices
Effect of Dividends on Equity Forward
Payoffs usually based on the equity price,
value of the portfolio or level of the index
Payoffs usually exclude any dividends paid by the component stocks
Bond and Interest Rate Forwards
Forward Contract on Individual Bonds and
Bond Portfolio
Forward Contract on Interest Rate (Forward
Rate Agreement) (FRA)
Differences between Bond and Equity
Bond has maturity (bond forwards must be exercised prior to maturity)
Bond has default risk (bond forwards must have provisions to define default)
Bond has embedded options
Bond value is affected by changes in interest rate
Forward Rate Agreement (settled by cash)
Contract to borrow / lend money at a specified rate at some future date
Long FRA: the obligation to borrow money at a specified rate and date
Short FRA: the obligation to lend money at a specified rate and date
Cash Settlement of Longing an FRA
Principal Borrowed (P)
Underlying Rate at Expiration (LIBOR)
Forward Contract Rate (FR)
Interest Profit / Loss (IP) / (IL)
Amount Paid by Borrower to Lender at
Expiration (A)
IP = P (LIBOR - FR) (No. of Days / 360))
PV of IP = IP / [1 + LIBOR (No. of Days /
360))]
IP when LIBOR > FR
IL when LIBOR < FR
A = P [(LIBOR - FR) (No. of Days / 360))] /
[1 + LIBOR (No. of Days / 360))]
Currency Forward
One party agrees to exchange a specified amount of one currency for a specified amount of another currency at a future date
Cash Settlement for Longing a Currency
Contract
Forward Exchange Rate (FEX)
Market Exchange Rate at Settlement (MEX)
Amount to be Exchanged (A)
Amount (Profit) received from Counterparty when FEX > MEX = A (FEX - MEX)
Amount (Loss) paid to Counterparty when
FEX < MEX = A (MEX - FEX)
Option Contracts
Option
A right but not an obligation to buy / sell a given asset at a specified price during a 2
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