CFA Level 1 Derivatives- -Complete Exam
Study Guide with Verified Answers |
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Derivatives ------- ✔ CORRECT ANSWER ✓✓A financial contract or instrument that derives its
value from the value of something else, known as the underlying. Derivatives transform the
performance of the underlying asset before paying out in the derivatives transaction. (Mutual
funds and ETFs simply pass on the returns of the underlying).
Derivatives are created and traded in two different types of markets: exchanges and over-the-
counter markets.
Exchange-traded derivatives markets ------- ✔ CORRECT ANSWER ✓✓Exchange-traded
derivatives (futures) are traded on specialized exchanges. Contracts are standardized and
backed by a clearinghouse. Standardization facilitates the creation of a more liquid market for
derivatives, however at the cost of flexibility. Liquidity is a function of trading interest and level
of uncertainty. Little trading interest and a high level of uncertainty lead to low liquidity. Market-
makers (ready to buy at once price and sell at another) and speculators (willing to take risks)
play big role in this market.
All clearing and settling is done through a clearinghouse and the clearinghouse provides a credit
guarantee. Exchanges are also transparent and has regulations.
Over-the-counter derivatives markets ------- ✔ CORRECT ANSWER ✓✓OTC derivatives
(forwards) do not trade in a centralized market and instead trade in an informal market. OTC
derivatives are customized instruments. Dealers (banks) play an important role in this market as
they buy and sell the customized derivatives to market participants and hedge away their risk.
Typically unable to find perfectly offsetting transactions so only some of the risk is laid off.
,OTC markets are not necessarily less liquid than exchanges but they are less regulated and offer
more privacy and flexibility than exchanges.
Forward Commitment ------- ✔ CORRECT ANSWER ✓✓A forward commitment is a legally
binding obligation to engage in a certain transaction in the spot market at a future date at terms
agreed upon today. They include forward contracts, futures contracts, and swap contracts.
Forward Contract ------- ✔ CORRECT ANSWER ✓✓Customized and private contracts between
two parties where one (the long position) has an obligation to buy an asset and the counterpart
(the short position) has an obligation to sell the asset at a fixed forward price and future date
that are agreed upon signing the contract. If the price increases, it benefits the buyer. Can be
written on equities, bonds, assets, or interest rates. Either physical delivery of the share or cash
settlement for difference between price of stock at settlement and the forward price.
There is a default risk associated with forward contracts.
Forward Contract valuing ------- ✔ CORRECT ANSWER ✓✓-Forward price (F) is determined at
contract initiation and does not change over the term of the contract. F(0,T).
-Value (V) of the forward contract changes over the term of the contract as the price of the
underlying changes V(0,T).
-Spot price (S) of the underlying asset also changes over the term of the contract S₀.
Vt(0,T) = S(t) - F(0,T)
Payoff - Long position
S(T) > F(0,T) => S(t) - F(0,T) => positive payoff
S(T) < F(0,T) => S(t) - F(0,T) => negative payoff
Payoff - Short position
S(T) > F(0,T) => -[S(t) - F(0,T)] => negative payoff
S(T) < F(0,T) => -[S(t) - F(0,T)] => positive payoff
, Cash and carry arbitrage => borrow at risk free rate and sell the forward, purchase the
underlying
Reverse cash and carry arbitrage => short the underlying and invest proceeds at risk free, buy
the forward
-The forward price at initiation is the unique price that yields zero value to the long and short
position - no-arbitrage forward price:
V(0,T) = S₀ - [F(0,T)/(1+r)^T] = 0
S₀ = [F(0,T)/(1+r)^T]
If there are costs θ and benefits γ incurred:
F[0,T] = (S₀ - γ - θ)(1+r)^t = S₀(1+r)^t - (γ - θ)(1+r)^t
1. Because neither the long nor the short pays anything to the other at initiation of a forward
contract, the value is 0 at initiation.
2. The forward price is the spot price compounded at the risk-free rate over the life of the
contract.
3. The forward price of an asset with benefits (costs) is the spot price compounded at the risk-
free rate over the life of the contract minus (plus) the future value of those benefits (costs).
Value - Long position
initiation = 0
during the life of the contract = S(t) - F(0,T)/(1+r)^(T-t)
at expiration = S(t) - F(0,T)
Value - short position
initiation = 0
during the life of the contract = F(0,T)/(1+r)^(T-t) - S(t)
at expiration = F(0,T) - S(t)
Study Guide with Verified Answers |
Guaranteed A+
Derivatives ------- ✔ CORRECT ANSWER ✓✓A financial contract or instrument that derives its
value from the value of something else, known as the underlying. Derivatives transform the
performance of the underlying asset before paying out in the derivatives transaction. (Mutual
funds and ETFs simply pass on the returns of the underlying).
Derivatives are created and traded in two different types of markets: exchanges and over-the-
counter markets.
Exchange-traded derivatives markets ------- ✔ CORRECT ANSWER ✓✓Exchange-traded
derivatives (futures) are traded on specialized exchanges. Contracts are standardized and
backed by a clearinghouse. Standardization facilitates the creation of a more liquid market for
derivatives, however at the cost of flexibility. Liquidity is a function of trading interest and level
of uncertainty. Little trading interest and a high level of uncertainty lead to low liquidity. Market-
makers (ready to buy at once price and sell at another) and speculators (willing to take risks)
play big role in this market.
All clearing and settling is done through a clearinghouse and the clearinghouse provides a credit
guarantee. Exchanges are also transparent and has regulations.
Over-the-counter derivatives markets ------- ✔ CORRECT ANSWER ✓✓OTC derivatives
(forwards) do not trade in a centralized market and instead trade in an informal market. OTC
derivatives are customized instruments. Dealers (banks) play an important role in this market as
they buy and sell the customized derivatives to market participants and hedge away their risk.
Typically unable to find perfectly offsetting transactions so only some of the risk is laid off.
,OTC markets are not necessarily less liquid than exchanges but they are less regulated and offer
more privacy and flexibility than exchanges.
Forward Commitment ------- ✔ CORRECT ANSWER ✓✓A forward commitment is a legally
binding obligation to engage in a certain transaction in the spot market at a future date at terms
agreed upon today. They include forward contracts, futures contracts, and swap contracts.
Forward Contract ------- ✔ CORRECT ANSWER ✓✓Customized and private contracts between
two parties where one (the long position) has an obligation to buy an asset and the counterpart
(the short position) has an obligation to sell the asset at a fixed forward price and future date
that are agreed upon signing the contract. If the price increases, it benefits the buyer. Can be
written on equities, bonds, assets, or interest rates. Either physical delivery of the share or cash
settlement for difference between price of stock at settlement and the forward price.
There is a default risk associated with forward contracts.
Forward Contract valuing ------- ✔ CORRECT ANSWER ✓✓-Forward price (F) is determined at
contract initiation and does not change over the term of the contract. F(0,T).
-Value (V) of the forward contract changes over the term of the contract as the price of the
underlying changes V(0,T).
-Spot price (S) of the underlying asset also changes over the term of the contract S₀.
Vt(0,T) = S(t) - F(0,T)
Payoff - Long position
S(T) > F(0,T) => S(t) - F(0,T) => positive payoff
S(T) < F(0,T) => S(t) - F(0,T) => negative payoff
Payoff - Short position
S(T) > F(0,T) => -[S(t) - F(0,T)] => negative payoff
S(T) < F(0,T) => -[S(t) - F(0,T)] => positive payoff
, Cash and carry arbitrage => borrow at risk free rate and sell the forward, purchase the
underlying
Reverse cash and carry arbitrage => short the underlying and invest proceeds at risk free, buy
the forward
-The forward price at initiation is the unique price that yields zero value to the long and short
position - no-arbitrage forward price:
V(0,T) = S₀ - [F(0,T)/(1+r)^T] = 0
S₀ = [F(0,T)/(1+r)^T]
If there are costs θ and benefits γ incurred:
F[0,T] = (S₀ - γ - θ)(1+r)^t = S₀(1+r)^t - (γ - θ)(1+r)^t
1. Because neither the long nor the short pays anything to the other at initiation of a forward
contract, the value is 0 at initiation.
2. The forward price is the spot price compounded at the risk-free rate over the life of the
contract.
3. The forward price of an asset with benefits (costs) is the spot price compounded at the risk-
free rate over the life of the contract minus (plus) the future value of those benefits (costs).
Value - Long position
initiation = 0
during the life of the contract = S(t) - F(0,T)/(1+r)^(T-t)
at expiration = S(t) - F(0,T)
Value - short position
initiation = 0
during the life of the contract = F(0,T)/(1+r)^(T-t) - S(t)
at expiration = F(0,T) - S(t)
