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.  Whenever we enter into a derivative contract based on any underlying asset, we determine its exercise price at the future date (mostly the strike price at the time of expiration of the contract).

b.  This strike price is generally different from the spot price at which the asset is currently trading. This price is usually arrived at, by adjusting the current spot price for the time value of money (giving due consideration to the risk and its premium). Also, the spot price is adjusted for the benefits of holding the assets and the cost of holding the same (which are usually quantified in monetary terms).

c.  There are three basic fundamental principles based on which the pricing and valuation of derivatives are made:

     i.  The Arbitrage Principle. The derivatives should be priced in such a manner that there exist no arbitrage opportunities. This means that the assets should be trading at such a fair price at all the markets during the same time, otherwise, there would be an opportunity for the traders to make arbitrage profits.

    ii.  The Replication Principle. It is the ability to create an asset or portfolio from another asset or portfolio, and/or derivative. Using the derivatives, we can replicate a contract by adding the risk-free returns to the spot price of the underlying assets.

   iii.  The Risk Neutrality Principle. Here, it is assumed that the investor is not risk-averse (A risk-averse investor is an investor who demands higher returns, i.e. risk premium on the riskier assets). While pricing the derivatives we assume that the investor is not affected by the risk. Thus, the spot price is only adjusted for the risk-free rate.

d.  The overall process of pricing the derivatives by arbitrage and risk neutrality is called arbitrage-free pricing. According to this principle, a derivative must be priced in such a manner that no arbitrage opportunity exists and there exists only one price for the derivative that earns the risk-free returns. That is,

Spot Price + Risk-Free Return = Future Strike Price

 

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