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LEVEL 1 DERIVATIVES

STUDY SESSION 17:

Study session 17 in the CFA Level 1 curriculum consists of six readings (60-65) covering derivatives. The material is still fairly
conceptual but is pretty lengthy. While the topic is only worth 5% of your Level 1 score, you will need it as a base for the 5% to 15%
in each of the next two exams. As with most of the CFA Level 1 curriculum, focus first on the basic concept and differences,
advantages and limitations of each type of derivative.

Derivative Markets and Instruments

Derivatives are called such because they are instruments that ‘derive’ their value from the value of an underlying asset. The value of
an option, futures contract or swap depends on the price of the asset on which it is written. How much you would pay for an option
on a share of Apple depends on how much a share of Apple stock is worth.

Derivatives are traded either over-the-counter or on an exchange. The distinction is important and very testable. Over-the-counter is
between two private parties while exchange traded is usually through a clearinghouse (a third party that takes both sides with each
party). Exchange-traded derivatives usually have less transaction costs, are standardized and expire on regular calendar dates. The
do not carry counterparty risk because of the clearinghouse and are usually marked –to-market with a margin. OTC derivatives have
counterparty risk because you don’t really know if the other party can deliver but they are completely customizable to your needs.

Forwards and futures are basically the same instrument except futures are exchange traded while forwards are OTC. Swaps are an
OTC agreement between two parties to exchange principal, i.e. an interest rate, currency or commodity.

An option gives the party the right to buy/sell an asset but not the obligation. The buyer can pay a small premium now for the
privilege of locking-in the buy/sell price on a later date but does not have to worry about the obligation to deliver. Besides the
derivatives material, options will be important in bonds and asset-backed securities as well.

Forward Markets and Contracts

Besides the basic concepts of a forward, the payoff calculation of a FRA is the most important and testable material here. The payoff
for a Forward Rate Agreement is:

((Expiration rate – Contract rate) (days in rate/360)) divided by ((1+epiration rate) (days in rate/360))
Multiplied by the principal on the contract.
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Think about it logically and the formula becomes easier to remember. You are looking for the difference in rates (adjusted for the
term of contract since rates are quoted on an annual basis) as a percentage of the expiration rate. This factor is then multiplied by
the contract principal (the notional) to get the payoff. *remember to use 360 days

Futures Markets and Contracts

Mostly conceptual stuff here with the focus on advantages of futures over forwards and the different participants in the futures
market.

Option Markets and Contracts

Know the basic concepts behind a put and call as well as how to calculate the payoff at expiration. Most options are pretty easy to
calculate but rate options get a little more complicated.

The payoff on a rate option is: (principal) *((exercise rate – rate at expirate)(days in rate/360))
*Remember, a rate option isn’t paid at expiration, it is paid the number of days in rate after the expiration (i.e. an option on 180-
day LIBOR that expires in 90 days would be paid in 270 days but the payoff amount is calculated at expiration.

The put-call parity formula can be a pain but you will need it here and it will appear again in the second exam, so spend the time to
learn it. Understand how puts and calls can be used to create a synthetic position.

Know the Greeks and their respective measures. Again, something were you just need the basics here but more detail in subsequent
exams. Three of the Greeks start with the same letter as the definitional word which is how I remembered them.

Delta- sensitivity to price change

Gamma- sensitivity to delta change

Rho – sensitivity to rate change

Theta – sensitivity to time change

Vega – sensitivity to volatility

Swap Markets and Contracts

Most swaps do not include an exchange of principal at initiation and the payments are netted but currency swaps do because the
notionals are in different monies. Be able to calculate the amounts exchanged at initiation as well as on settlement dates.

Be able to calculate the basic payments for an equity swap for both parties and the reasons one would enter into a swap (i.e. protect
capital gains while avoiding taxes or to hedge volatility)
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Risk Management Applications of Options Strategies

The two main strategies are covered calls and protective puts (also called portfolio insurance). You’ll need to understand the basics
of each, why investors might use them and to calculate the payoff at expiration.

Protective put: buying a put option against a long position has limited downside but maintains upside potential.

Covered call: Selling call options against a long position has more downside risk and limited upside potential but involves
collecting a premium instead of paying for protection. The strategy is best if rates/prices do not change.