Study Session 17 Derivative Investments

Study Session 17

Derivative Investments

Derivatives − financial instruments that offer a return based on the return of some underlying asset − have become increasingly important and fundamental in effectively managing financial risk and creating synthetic exposures to asset classes. As in other security markets, arbitrage and market efficiency play a critical role in establishing prices and maintaining parity.


This study session builds the conceptual framework for understanding derivative investments (forwards, futures, options, and swaps), derivative markets, and the use of options in risk management.


LOS

Reading 70: Derivative Markets and Instruments

The candidate should be able to:

a. define a derivative and differentiate between exchange-traded and over-thecounter
derivatives;
b. define a forward commitment and a contingent claim, and describe the basic
characteristics of forward contracts, futures contracts, options (calls and puts),
and swaps;
c. discuss the purposes and criticisms of derivative markets;
d. explain arbitrage and the role it plays in determining prices and promoting
market efficiency.

Reading 71: Forward Markets and Contracts

The candidate should be able to:

a. differentiate between the positions held by the long and short parties to a
forward contract in terms of delivery/settlement and default risk;
b. describe the procedures for settling a forward contract at expiration, and discuss
how termination alternatives prior to expiration can affect credit risk;
c. differentiate between a dealer and an end user of a forward contract;

d. describe the characteristics of equity forward contracts and forward contracts on
zero-coupon and coupon bonds;
e. describe the characteristics of the Eurodollar time deposit market, define LIBOR
and Euribor;
f. describe the characteristics of forward rate agreements (FRAs);
g. calculate and interpret the payoff of an FRA and explain each of the component
terms;
h. describe the characteristics of currency forward contracts.

Reading 72: Futures Markets and Contracts
The candidate should be able to:
a. describe the characteristics of futures contracts, and distinguish between futures
contracts and forward contracts;
b. differentiate between margin in the securities markets and margin in the futures
markets; and define initial margin, maintenance margin, variation margin, and
settlement price;
c. describe price limits and the process of marking to market, and compute and
interpret the margin balance, given the previous day’s balance and the new
change in the futures price;
d. describe how a futures contract can be terminated by a close-out (i.e., offset) at
expiration (or prior to expiration), delivery, an equivalent cash settlement, or an
exchange-for-physicals;
e. describe the characteristics of the following types of futures contracts: Eurodollar,
Treasury bond, stock index, and currency.
Reading 73: Option Markets and Contracts
The candidate should be able to:
a. define European option, American option, and moneyness, and differentiate
between exchange-traded options and over-the-counter options;
b. identify the types of options in terms of the underlying instruments;
c. compare and contrast interest rate options to forward rate agreements (FRAs);
d. define interest rate caps, floors, and collars;
e. compute and interpret option payoffs, and explain how interest rate option
payoffs differ from the payoffs of other types of options;
f. define intrinsic value and time value, and explain their relationship;
g. determine the minimum and maximum values of European options and
American options;
h. calculate and interpret the lowest prices of European and American calls and
puts based on the rules for minimum values and lower bounds;
i. explain how option prices are affected by the exercise price and the time to
expiration;
j. explain put-call parity for European options, and relate put-call parity to arbitrage
and the construction of synthetic options;
k. contrast American options with European options in terms of the lower bounds
on option prices and the possibility of early exercise;
l. explain how cash flows on the underlying asset affect put-call parity and the
lower bounds of option prices;
m. indicate the directional effect of an interest rate change or volatility change on
an option’s price.

Reading 74: Swap Markets and Contracts
The candidate should be able to:
a. describe the characteristics of swap contracts and explain how swaps are
terminated;
b. define and give examples of currency swaps, plain vanilla interest rate swaps,
and equity swaps, and calculate and interpret the payments on each.

Reading 75: Risk Management Applications of Option Strategies
The candidate should be able to:
a. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of the
strategies of buying and selling calls and puts, and indicate the market outlook
of investors using these strategies;
b. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of a
covered call strategy and a protective put strategy, and explain the risk
management application of each strategy.


Specified Readings

"Derivative Markets and Instruments"
Ch. 1, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Forward Markets and Contracts"
Ch. 2, pp. 25-37, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Futures Markets and Contracts"
Ch. 3, pp. 81-103, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Option Markets and Contracts"
Ch. 4, pp. 159-194, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Swap Markets and Contracts"
Ch. 5, pp. 269-285, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Risk Management Applications of Option Strategies"
Ch. 7, pp. 411-429, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)