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.  As per the above discussion, the future price of the derivative equals the current spot price plus the return at the risk-free rate. That is,

F = S (1+r)T

Where,

              F            = Future Price

              S            = Spot Price of the Asset

              r             = Risk-Free Rate

              T            = Time Period of Contracts

b.  The price of the forward or the future contracts is the forward price that is specified in the contract. This price of the contract remains the same during the life of the contract. It is the price at which the contract would be exercised at the expiration.

c.  The value of a future or forward contract is its intrinsic value that keeps changing during the life of the contract. At the initiation of the contract its value is zero. The value may increase or decrease during its life depending upon the changes in the spot price.

     i.  At initiation, the value of the forward contract is zero.

    ii.  The value at expiration is ST – F.

   iii.  The value during the life of the contract is: VT = ST – [F/(1+r)(T-t)]

d.  The price of the forward contract is also dependent upon the benefits and cost of holding the assets. The benefits decrease the price of the contract whereas the costs increase the price.

e.  The benefits associated with these contracts could be monetary as well as non-monetary. The monetary benefits may be in the form of dividends or interest. Whereas, the non-monetary benefits are in the form of convenience yield.

f.  The cost of holding assets is also referred to as carrying costs.

Adding the impact of cost and benefit in the calculation of price, we get the following equation:

S0 = [E(St) / (1 + Rf + Risk Premium)T] + (PV of benefits from holding the asset for time T) – (PV of cost for holding the asset for the time T)

Where,

S0              = Current Spot Price

T                = Expected Holding Period

E(St)          = Expected value of the asset at time T

 

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