Course Content
DERIVATIVE MARKETS AND INSTRUMENTS
This chapter is covered under study session 19, reading 48 of the study material as provided by the CFA Institute. After reading this chapter, the candidate should be able to: a. define a derivative and distinguish between exchange-traded and over-the-counter derivatives; b. contrast forward commitments with contingent claims; c. define forward contracts, futures contracts, options (calls and puts), swaps, and credit derivatives and compare their basic characteristics; d. determine the value at expiration and profit from a long or a short position in a call or put option; e. describe purposes of, and controversies related to, derivative markets; and f. explain arbitrage and the role it plays in determining prices and promoting market efficiency.
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Introduction
LOS A: Derivatives
LOS B and C: Commitments Vs. Contingent Claims
LOS D: Value at Expiration and Profit for Call and Put Options
LOS E: Purposes/ Controversies Related to Derivatives Market
LOS F: Arbitrage
BASICS OF DERIVATIVE PRICING AND VALUATION
This chapter is covered under study session 16, reading 49 of the study material as provided by the CFA institute. After reading this chapter, the candidate should be able to: a. explain how the concepts of arbitrage, replication, and risk neutrality are used in pricing derivatives; b. distinguish between value and price of forward and futures contracts; c. explain how the value and price of a forward contract are determined at expiration, during the life of the contract, and at initiation; d. describe monetary and nonmonetary benefits and costs associated with holding the underlying asset and explain how they affect the value and price of a forward contract; e. define a forward rate agreement and describe its uses; f. explain why forward and futures prices differ; g. explain how swap contracts are similar to but different from a series of forward contracts; h. distinguish between the value and price of swaps; i. explain how the value of a European option is determined at expiration; j. explain the exercise value, time value, and moneyness of an option; k. identify the factors that determine the value of an option and explain how each factor affects the value of an option; l. explain put–call parity for European options; m. explain put–call–forward parity for European options; n. explain how the value of an option is determined using a one-period binomial model; o. explain under which circumstances the values of European and American options differ.
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Introduction
LOS A: Pricing of Derivatives
LOS B, C, D, and E: Difference Between Value and Price of Forward & Future Contract
LOS F: Forward Rate Agreement
LOS G: Reasons for Differences in the Forward and Future Prices
LOS H and I: Swaps
LOS J: Option Value
LOS K: Effect on Valuation
LOS L: Put-Call Parity
LOS M: Put-Call-Forward Parity
LOS N: Binomial Model
LOS O: European Vs. American Option
Derivatives
About Lesson

a.  The derivative may be defined as a financial contract between two parties whose value depends upon the value of some other underlying asset.

b.  These instruments allow the transfer of risk.

c.  It is a legal contract where a buyer agrees to buy and a seller agrees to sell a specific underlying asset at a specified strike or contract price, to be squared on a specified expiration date.

d.  The legal contract can be of two types, i.e. rights (i.e. the contingencies), and the commitments (e. the obligations) of the parties.

e.  The whole mechanism of derivative contracts results in a no-profit-no-loss for all the parties involved in the contract, taken together. Thus, it is also called a ‘zero-sum-game’.
Thus, the derivative contracts do not create any wealth, they simply transfer it. These involve both transfers of return and risks. So, when one party makes a dollar of profit, the other one loses the same.

f.  The derivatives can be used for hedging (i.e. risk management) and speculation (i.e. risk assumption).

1.1.           The Structure of Derivative Market

The derivative markets basically consist of the following:

1.1.1.       Exchange Traded Instruments

a.  Exchange-traded markets basically deal in futures and options contracts.

b.  They are basically characterized by standardized contracts, whose terms and conditions are specified by the exchange.

c.  Trading on an exchange involves no counterparty risk. This is mainly because all the parties enter into the contract with the clearinghouses (and not amongst themselves), and it is the clearing corporation that assumes such risk. They minimize such risks by keeping the margin in the hands.

d.  There is a daily settlement of all the contracts, and such contracts are marked-to-market.

e.  The exchange-traded transactions are completely transparent. All the information on all the transactions is disclosed to the exchange and regulatory bodies. The transactions on the exchange are tightly regulated.

1.1.2.       Over-the-Counter Market

a.  This market basically deals in the forward and swap contracts.

b.  It is mainly the market for the dealers, who are mostly the banks (that are the members of International Swaps & Derivatives Association or ISDA).

c.  Rather than standardized contracts, on the OTC market, we can find customized contracts. This results in a lack of liquidity in such markets.

d.  There is a comparatively lesser degree of regulation in an OTC market.

e.  Unlike the exchange-traded market, where there is a high degree of transparency, the OTC market does have some privacy.

f.  As per the Dodd-Frank Act, some OTC contracts that can be standardized should be standardized; and a number of contracts would be cleared through central clearing agencies.

 

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