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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