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

a.  There are two types of options, the American option (which can be exercised anytime during the period of the contract) and the European contract (which can only be exercised on the expiry of the contract). Both the options can, however, be traded anytime during the contract period.

b.  So some of the important notations while valuing/pricing these options are:

c0 = Value of European call at time 0.
cT    = Value of European call at time T.
C0   = Value of American call at time 0.
CT   = Value of American call at time T.
p0    = Value of European put at time 0.
pT    = Value of European put at time T.
P0    = Value of American put at time 0.
PT    = Value of American put at time T.

c.  The options are said to be in-the-money if it is beneficial for the holder/buyer of the option to exercise the same. On the other hand, if it is not beneficial for the holder of the option to exercise the same, it is called out-of-money. If the spot price equals the exercise price at the expiration of the contract, it is called at-the-money (ATM)

d.  The value of an option is the sum of its intrinsic value and the time value of money.

V = IV + TV

1.1.           Call Options

a.  If we recall the definition of a call option, under an option, the buyer has the right to buy and the seller has an obligation to sell a specific underlying asset at a pre-decided strike price by certain expiration date.

b.  Suppose if ST is the spot price of the asset and X is the exercise price of the underlying asset then there would be the following payoffs:

Pay-Offs

ST > X
Holder will exercise the option

ST < X
Holder will not exercise the option

Long Call

ST – X

0

Short Call

-(ST – X)

0

 

In the above cases, the profits would be as follows:

Profits

ST > X
Holder will exercise the option

ST < X
Holder will not exercise the option

Long Call

(ST – X) – C0

-C0

Short Call

C0 – (ST – X)

C0

 

1.2.           Put Options

a.  If we recall the definition of a put option, under such an option, the buyer has the right to sell and the seller has an obligation to buy a specific underlying asset at a pre-decided strike price by certain expiration date.

b.  Suppose, if ST is the spot price of the asset and X is the exercise price of the underlying asset then there would be the following pay-offs in the case of a put option:

Pay-Offs

ST < X
Holder will exercise the option

ST > X
Holder will not exercise the option

Long Call

X – ST

0

Short Call

-(X – ST)

0

In the above cases, the profits would be as follows:

Profits

ST < X
Holder will exercise the option

ST > X
Holder will not exercise the option

Long Call

(X – ST) – P0

-P0

Short Call

P0 – (X – ST)

P0

 

 

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