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Cfa1 8 Derivatives Notes

Finance Notes > CFA Level 1 Notes

This is an extract of our Cfa1 8 Derivatives document, which we sell as part of our CFA Level 1 Notes collection written by the top tier of University Of London (examined By LSE) students.

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CFA Level 1

Derivatives

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
Future
A standardized (exchange traded) contract between two parties to sell and buy a particular asset at a specified price and time
Swap
Agreement between two parties to exchanges a series of future cash flows
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
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 1 CFA Level 1

Derivatives

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.
Law of One Price
Situation in which no arbitrage opportunities are available
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
Settlement of Forward Contract
Deliverable Forward
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

1. Enter into an opposite contract with an expiration date equal to the remaining time of the original contract

2. New contract can be entered into with the counterparty by paying to him the difference between the original and new contracts

3. New contract can be entered into with a third party so that the obligation to him 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

1. Bank / Financial institution which enters a forward contract with an end user who has an 2 CFA Level 1

2. Derivatives

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))]

3 CFA Level 1

Derivatives

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 specified period of time
Call Option
A right but not an obligation to buy a given asset at a specified price during a specified period of time
Put Option
A right but not an obligation to sell a given asset at a specified price during a specified period of time
Call Option Buyer
Has the right to buy a given asset from the option seller at a specified price during a specified period of time
Call Option Seller
Has the obligation to sell a given asset to the option buyer at a specified price during a specified period of time if the buyer exercises the option
Put Option Buyer
Has the right to buy a given asset from the option seller at a specified price during a specified period of time
Put Option Seller
Has the obligation to sell a given asset to the option buyer at a specified price during a specified period of time if the buyer exercises the option 4

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