JuiceNotes TM

- By FinTree

eBook 9

Derivatives

CFA® Level 1 JuiceNotesTM 2017

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 Derivative Markets and Instruments
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LOS a Define a derivative

A derivative is a security that derives its value from the value of underlying asset

Exchange-traded derivatives - These are standardized and backed by a clearinghouse

Eg. Options and Futures

Over-the-counter derivatives - These are traded by dealers in a market with no central

location. OTC markets are unregulated and each
contract is with a counterparty
This may expose the owner to default risk
Eg. Forwards, swaps and options

LOS b Forward commitments Contingent claims

Legally binding promise

Claim that depends on a
to perform some action in
particular event
the future

Eg. forwards, futures and

swaps
e Eg. Options and Credit
derivatives
re
LOS c 1
Forwards Futures

Buyer (long) agrees to buy an asset These are forward contracts that are
nT

(physical/financial) from seller (short) at standardized and exchange-traded

specific price on specific date in future
Require security deposit (margin)
Do not require payment at initiation
Liquid
Customized contracts
Backed by a clearinghouse
Illiquid
Fi

Require daily cash settlement (mark to

There is default risk associated market)

Do not trade in organized markets Traded in secondary market

Not regulated Subject to regulation

Both Forwards and Futures are deliverable/cash-settled contracts

Both of them have contract value of zero at initiation

Settlement price - It is average of the prices of the trades during the last period of trading (closing period)
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Initial margin - It is the amount that is required to be deposited while opening a futures account
Maintenance
margin - It is the minimum amount of margin that must be maintained in a futures account

Equity account - Investors are required to bring the margin back up to the maintenance margin if
(variation margin) the margin balance in the account falls below maintenance margin because of
daily cash settlement
Futures account - Investors are required to bring the margin back up to the initial margin amount
(variation margin)

2 Options X = Strike price

P = Premium

Call Put
B b b B
Long Short Long Short

Right to buy Obligation to sell Right to sell Obligation to buy

Pays premium Receives premium Pays premium Receives premium

Maximum
profit

Maximum
loss
Infinite

Premium
Premium

Infinite e X−P

Premium
Premium

X−P
re
Breakeven Breakeven
Point for call: X + P Point for put: X−P

ª Seller of the option is also called as writer

ª Premium is also referred to as price of the option

nT

ª American options - Can be exercised at any time between purchase date and expiration date

ª European options - Can be exercised only on expiration date

ª Bermudan options - Can be exercised only on certain days. Eg. Once a month

ª At expiration, an American option and a European option on same asset with same strike
Fi

price are identical

Eg.
X = 100, P = 10 Calculate Profit/Loss for long and short if,

Call S = 0 60 110 150 200 Put S = 0 60 90 150 200

Profit/ Long = 10 10 0 40 90 Profit/ Long = 90 30 0 10 10

Loss Short = 10 10 0 40 90 Loss Short = 90 30 0 10 10

Breakeven Point Breakeven Point

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3 Swaps Agreements to exchange a series of payments on periodic settlement dates

At each settlement date, the two payments are netted so that only one
payment is made

The length of the swap is termed as tenor

Simplest type of swap is plain vanilla interest rate swap

Plain vanilla interest rate swap

Eg. Fixed rate - 8% Floating rate - LIBOR + 2% Notional principal = 100,000

Fixed rate
payer
−8% −8% −8%
A

LIBOR = 6% LIBOR = 9% LIBOR = 4%

Floating rate 8% 11% 6%
Floating rate
Net rate 0% +3% −2%
receiver
Net amount

e 0 3000 2000
re
Will be Will be paid
received by A by A

Some important points of Swaps

ª Swaps do not require payment at initiation by either party (except currency swaps)
nT

ª They are custom instruments

ª They are not traded in any organized secondary market
ª They are largely unregulated
ª There is default risk associated with swaps
ª Participants in the swaps market are generally large institutions. Individuals are rarely
participants of swap market
Fi

4 Credit derivatives It is a contract that provides a bondholder (lender) with

protection against a downgrade or a default by the borrower

Credit default swap (CDS) is the most common type of credit

derivative. It is essentially an insurance contract against default

Another type of credit derivative is a credit spread option. It is a

call option that is based on a bond’s yield spread relative to its
benchmark
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LOS d Criticism of derivatives Benefits of derivatives

è Too risky è Provides price information

è Because of the high leverage è Allows risk to be managed and
involved in derivatives payoffs, they shifted among market participants
are sometimes likened to gambling è Reduces transactions costs

LOS e Arbitrage It means riskless profit

If a return greater than the risk-free rate can be earned by
holding a portfolio of assets that produces a certain (riskless)
return, then an arbitrage opportunity exists
It is often referred to as the law of one price

Two arbitrage arguments

1 Law of one price Two portfolios that have identical cash flows in the
future, should have the same price

Sip Pepsi Be Cool

S+P
Stock + Put
=
e B+C
Bond + Call
re
Protective Put Fiduciary Call

2 Borrow at RFR and invest at a return higher than RFR (if reurn is certain)
nT
Fi
 Basic of Derivative Pricing and Valuation
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LOS a
1 Costs of owning an asset Benefits of owning an asset

Storage cost Monetary Non-Monetary

Insurance cost

Opportunity cost of funds

that are invested in the asset Dividend payment Referred to as
on stock Convenience yield

Interest payment Intangible benefit

on bond of holding the asset

Net cost of carry = FV of costs + Interest cost − FV of benefits

2 Risk-averse Risk-neutral Risk-seeking/loving

investor investor investor

e
re
An investor that simply Such investor has no An investor that prefers
dislikes risk preference regarding risk more risk to less

Given two He would be indifferent Given two

investments that have
equal expected returns,
a risk-averse investor
will choose the one
nT
between two such investments that have
investments equal expected returns,
a risk-loving investor
will choose the one

with less risk with more risk

Sip Pepsi Be Cool

S+P = B+C
Stock + Put Bond + Call

When the equality holds we say the derivative is currently at its no-arbitrage price
Fi

No-arbitrage derivative price is sometimes called risk-neutral pricing

LOS b Value of forwards and futures - Zero at initiation

Price of forwards and futures - Spot × (1 + RFR)n
S = 170 Long value - +ve
Eg. Spot (S) = 100
Forward = 110 S = 130 Long value - +ve

S = 100
Long value - 0 S = 90 Long value - −ve
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LOS c Value of the contract

S =100 S =130 Long = 110

0 0.6 1

Price of the contract 130 X (1+10%)0.4 = 135

Value at expiration (1) - 135 - 110 = 25

25 = 24.06
Today (0.6) -
(1+10%)0.4

Value of the contract today (0.6) = 24.06

LOS d Value of forward at

any point in time Spot price + PV costs − PV benefits − Forward price
T-t
(1 + RFR)

LOS e Forward Rate Agreement (FRA)

It is a forward contract where the underlying asset is the interest rate

Long Forward Contract Short Forward Contract

Right and Obligation e Right and Obligation

re
to borrow to lend/invest

Benefit if interest Benefit if interest

rate increases rate decreases
nT

30 60
1 X 3 FRA =

60 90
2 X 5 FRA =
90 90
3 X 6 FRA =
60 120
Fi

2 X 6 FRA =

0 30 90
FRA 1 X 3
Borrow for 60 days, after 30 days

Lend for 30 days

0 30 90
Synthetic FRA 1 X 3

Borrow for 90 days

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LOS f Relation between forwards and futures

Preference for
Interest rates Ç Asset Ç $$$ Invest at higher rate
futures

Preference for
Interest rates È Asset È −$$$ Borrow at lower rate
futures

If interest rates are uncorrelated with futures prices, futures and forwards have the same value

LOS g & h Interest rate swap is equivalent to forward rate agreement

when forward contract rate equal to the swap fixed rate

Can be replicated by using a series of

Payer swap
LONG off market FRAs

Can be replicated by using a series of

Receiver swap
SHORT off market FRAs

Off market FRAs - FRAs that do not have value of zero at inititation

LOS i & j Moneyness - It refers to whether an option is in the money or out of the money

e
In the money - If immediate exercise of the option generates positive
payoff, it is said the option is in the money.

At the money - If immediate exercise of the option generates neither

re
positive payoff nor negative payoff, it is said the option is at the money.

Out the money - If immediate exercise of the option generates negative

payoff, it is said the option is out of the money.

Call option Put option

nT

In the money In the money

S>X X>S

Out of the money Out of the money

S<X X<S

At the money At the money

Fi

S=X X=S

Intrinsic value and time value

Eg. S = 9000 Intrinsic value(exercise value) Option Premium = Time Value + Intrinsic Value
X = 8800
= S - X = 200
P = 225 Intrinsic value is never negative
Expiry - 21 days Time value(speculative value) Time value can be negative if the option is deep
= P - Intrinsic Value = 25 in the market for European put options
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LOS k Factors that determine the value of an option

Value of call Value of put

Factor
option option

Spot Ç Ç È

Strike Ç È Ç

Volatility Ç Ç Ç

Maturity Ç Ç Ç

RFR Ç Ç È

Dividend yield Ç È Ç

Synthetic call S+P-B Synthetic put B+C-S

If RFR Bond
S+P-
X
(1 + RFR)n

Call e If RFR
X
(1 + RFR)n

Bond
+C-S

Put
re
LOS l Put-call parity

Sip Pepsi Be Cool

S+P = B+C
nT

Stock + Put Bond + Call

Protective Put Fiduciary Call

LOS m Put-call forward parity for European options

Fi

F = S0 X (1 + RFR)n
F
S=
(1 + RFR)n

Put-call parity - S + P = B + C
F X +C
Put-call forward parity - +P =
(1 + RFR)n (1 + RFR)n

F-X +P = C
(1 + RFR)n
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LOS n Value of an option using one-period binomial model

Eg. S = 100 X = 80 Uptick factor = 1.25 RFR = 10% Downtick factor = 1/1.25 = 0.8

(1 + RFR) − D (1 + 0.1) − 0.8

Risk neutral probability - = = 66.67%
U-D 1.25 − 0.8

Su
100 x 1.25
= 125
IV = 45 TV = 0
%
66.7
S 100
33.
3%
280 x 0.87
= 245.61 IV = 0 TV = 0
Sd

45 X 66.7%
Expected value of the option in one period - = 27.27
(1 + 0.1)

LOS o Prices of European and American options will be equal unless

the right to exercise prior to expiration has positive value

If there is no benefit of early exercise then value of American

call option is equal to European call option (AO = EO)

e
For a call option on an asset that has no cash flows during its
life, there is no advantage to early exercise
re
Two scenarios where early exercise is useful:

ΠAmerican call - Expecting significant amount of dividend

 American put that is deep in the money

nT
Fi
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Risk Management Applications of Option Strategies

LOS a Graphs of options

Profit Profit

X
P

X+P Stock X+P Stock

0 BEP price 0 BEP price
P
X

Long Call Short Call

Profit Profit

X−P

X-P Stock
e X-P
X

Stock
re
0 BEP price 0 BEP price

X
X−P
Long Put Short Put

ª Long is always below zero

nT

ª Short is always above zero

ª Call has unlimited profit/loss

ª Put has limited profit /loss

Fi

LOS b Covered call Protective put

ª Buying a stock and selling ª Buying a stock and put
short (writing) the call
ª Purpose is to protect against
ª Purpose is to earn premium decline in the value of stock

ª Maximum profit = X − S + P ª Maximum profit = Unlimited

ª Maximum loss = S − P ª Maximum loss = S − X + P