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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.

The following is a more accessble plain text extract of the PDF sample above, taken from our CFA Level 1 Notes. Due to the challenges of extracting text from PDFs, it will have odd formatting:

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

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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